Friday, December 05, 2008

That isn't what I had in mind

Lost 500,000 jobs? Almost 200,000 worse than expected? And yet bonds sell off?

This isn't a case of whisper numbers being worse or any such thing. Its a matter of bonds being massively overbought at the same time we're looking at a 3 and 10-year auction next week. Below is the intra-day chart, the green line is the announcement of NFP.

Notice that about 10AM, with stocks off sharply, the 10-year was about 1/2 point lower. It manages to rally to near flat a couple times but basically is down all day. So despite a horrible NFP, every time 10's rally a little, someone is there to short it. I think that's classic pre-auction behavior. I expect a significant sell-off, maybe into the 2.90% area on 10's before the auction, then a rally after that.

And what of the job losses? We are getting a series of extremely bad economic data points from a tumultuous October. The question is whether this is the first salvo of a self-feeding downward spiral, or is it a matter of taking the big pain now so that we see less pain later. In the later scenario, the economy contracts rapidly at the beginning of the recession, then levels out for a while before rebounding.
I don't think its a self-feeding downward spiral, but it could become one. The best policy now is for the Fed to target mortgage rates through open market purchases. Note that just a few days ago, 30-year fixed-rate mortgages were 6%. If they could get down to 4.5%, which isn't out of the question given how low Treasury rates are, that would make a massive difference in affordability. 1.5% interest savings is $625 per month on a $500,000 mortgage. That could start to make a real difference in the housing market.
Until housing turns, the economy keeps getting worse.


Advant Guard said...

10-yr auction? Didn't that happen last month? I prefer to believe that people bailed from the treasury market to jump into the stock market when the S&P held above the 812 level.

BT said...

You might find this post from Calculated Risk on house prices and interest rates of interest.

jesse said...

Yes do read the CR article. In order for the Treasury and Fed to game the long market, it would take huge amounts of money to do so. If the economy can only turn around after housing finds a bottom, slowing down the housing correction, even if it were possible by gaming interest rates, seems counterproductive. It's worth clarifying if you want housing to turn in real or nominal terms, or are you talking sales?

STF said...

Recently found this blog . . . very good . . .thanks!

Thanks for the CR link.

Regarding Tsy and Fed targeting longer rates, there's of course no operational constraint to their abilities to do so, no matter how much "money" it takes. The issue, as usual, is will.

Lockstep said...

Read the CR article and parsed out some of Bernanke's comments. Being a person new to fixed income investing, I saw no logic in the low 30 year rates and looked to build a TLT short position. Needless to say after learning about Bernanke's targeting bent, I scuttled those positions quickly.

Here is what I found from the speech...

Here is the famous quote ... "But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."

Here is what Bernake says about the problem of deflation and the GD...

"Although deflation and the zero bound on nominal interest rates create a significant problem for those seeking to borrow, they impose an even greater burden on households and firms that had accumulated substantial debt before the onset of the deflation. This burden arises because, even if debtors are able to refinance their existing obligations at low nominal interest rates, with prices falling they must still repay the principal in dollars of increasing (perhaps rapidly increasing) real value. When William Jennings Bryan made his famous "cross of gold" speech in his 1896 presidential campaign, he was speaking on behalf of heavily mortgaged farmers whose debt burdens were growing ever larger in real terms, the result of a sustained deflation that followed America's post-Civil-War return to the gold standard.4 The financial distress of debtors can, in turn, increase the fragility of the nation's financial system--for example, by leading to a rapid increase in the share of bank loans that are delinquent or in default. Japan in recent years has certainly faced the problem of "debt-deflation"--the deflation-induced, ever-increasing real value of debts. Closer to home, massive financial problems, including defaults, bankruptcies, and bank failures, were endemic in America's worst encounter with deflation, in the years 1930-33--a period in which (as I mentioned) the U.S. price level fell about 10 percent per year. "

Here is the really interesting part, the fact that we may see Fed manipulated long term rates for a DECADE! This would kill our prospective TLT shorts and tells me we need to be long TLT for a while.

"Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond-price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951.10 Prior to that agreement, which freed the Fed from its responsibility to fix yields on government debt, the Fed maintained a ceiling of 2-1/2 percent on long-term Treasury bonds for nearly a decade."

Bernanke, in 2002 remember, mentions loaning through the discount window, taking all kinds of assets as collateral for Fed lending, just as we have seen them do this year.

Here is how Bernanke wraps up the speech...

Sustained deflation can be highly destructive to a modern economy and should be strongly resisted. Fortunately, for the foreseeable future, the chances of a serious deflation in the United States appear remote indeed, in large part because of our economy's underlying strengths but also because of the determination of the Federal Reserve and other U.S. policymakers to act preemptively against deflationary pressures. Moreover, as I have discussed today, a variety of policy responses are available should deflation appear to be taking hold. Because some of these alternative policy tools are relatively less familiar, they may raise practical problems of implementation and of calibration of their likely economic effects.
For this reason, as I have emphasized, prevention of deflation is preferable to cure. Nevertheless, I hope to have persuaded you that the Federal Reserve and other economic policymakers would be far from helpless in the face of deflation, even should the federal funds rate hit its zero bound.19"

STF said...

Lockstep . . . Nice quotes . . . thanks for taking the time to post them. Sounds like a central banker who might actually understand that he can set financial asset prices given a flexible exchange rate environment. Of course, the Tsy could simply stop issuing securities and the rate on its new debt would simply be the rate paid on reserves (though some maturities are already yielding less than that!).