In the middle of the various crises in which we presently find ourselves there has been something else going on. As the leader of the pack in this area is the United States we can start there.
U.S. Treasury yields bounced higher on Monday, continuing their upward momentum from last week as the Federal Reserve moves closer to easing off its pandemic-era policies.
The yield on the benchmark 10-year Treasury note climbed above the key 1.5% level in early trading, at one point rising above 1.51% ( CNBC)
There is quite a value judgement about the US Federal Reserve there but let us stay for the moment with the concept of a higher benchmark bond yield. There is a bit of a yo-yo here because it was only a week ago that it was 1.3% as there was a rush to bonds from those panicking about Evergrande. Also and in some ways more significant due to its role in the mortgage market there is this.
And another down leg for bonds overnight as 30s now comfortably above key 2% level ( @fullcarry)
The Impact
The first port of call is likely to be the mortgage market as the move in the long bond pushes borrowing rates higher. That will also impact on all longer-term businesses and of course the US government just as it plans this.
Senate Majority Leader Chuck Schumer and House of Representatives Speaker Nancy Pelosi provided no details on how they would pay for Biden’s proposed $3.5 trillion social spending plan. ( Reuters)
The whole issue here is dragging on but the plan will end up with more borrowing which means the US government will not appreciate higher financing costs.
The other impact is that these higher yields are followed around the world in a type of ripple effect.
The Causes
I am not as convinced as the media are that the so far mythical Taper is the driving force here. After all what has really changed over the past week on that front? Yes we have more vague promises from the US Federal Reserve but we have had those before and with more signs of a world economic slow down appearing it does not seem to be getting more likely.
Local governments in Zhejiang, Jiangsu, Yunnan and Guangdong provinces have asked factories to limit power usage or curb output.
Some power providers have sent notices to heavy users to either halt production during peak power periods that can run from 7 a.m. and 11 p.m., or shut operations entirely for two to three days a week. ( Reuters)
Power cuts in China just add to the economic output problems there. The New York Fed suspended its GDP Nowcast at the beginning of this month which is not especially auspicious and on Friday slashed its future growth expectations.
The mean forecast for real GDP growth (Q4/Q4) is 5.3, 1.7, 0.8, and 0.7 percent in 2021, 2022, 2023, and 2024, respectively, compared to 5.4, 2.6, 1.7, and 1.0 percent in June.
The debt ceiling is not entirely convincing either. There are obvious risks if the US is unable to raise the present US $28.4 trillion dollar ceiling. But we have been down this road more than a few times now and opposition is in general about the opponents getting approval for some of their favourite plans, rather than any willingness to shut down US government and eventual default. So we might get a partial shut down for a few days but then once the pork barrel deals are struck, on we go.
Convexity and Foreign Buyers
By contrast I think these are in play and convexity is a curious one in a way. Let us go back to February when Reuters looked at this.
The rise in Treasury yields has created the need for investors who hold mortgage-backed securities (MBS) to reduce the risks on the loans they manage to counter the negative effects of slower loan prepayments when interest rates climb, a move known as “convexity hedging”.
This is similar in a way to being short gamma in an options position because you end up doing what you do not want to do which is responding to a fall in prices by selling.
MBS investors such as insurance companies and real estate investment trusts who need to maintain a certain duration target would have to reduce that duration by either selling Treasury futures or by buying interest rate swaps where they would exchange a fixed coupon with another investor for a floating rate, a move that effectively reduces the duration of an asset.
In a piece of timing so bad it is almost admirable the Financial Times told us this a weel ago.
Foreign investors cannot get enough US government debt, which analysts say could help soften the blow when the Federal Reserve starts to cut back its own bond-buying programme this year. Overseas buyers snapped up more than a quarter of the $41bn of 10-year notes on offer in August, the highest percentage in three years. At the equivalent auction in July, foreign investors took 16 per cent. At the two-year auction in August, investors bought 22 per cent, the highest since December 2019.
Poor old Tom is probably lying low right now.
“It is still very attractive for global investors to buy Treasuries,” said Tom Graff, head of fixed income at asset manager Brown Advisory. “We expect foreign demand will remain quite strong for the foreseeable future.”
In my career Japanese overseas buying is a consistent reverse indicator.
Demand has been particularly strong in recent months from China and Japan, the two biggest foreign holders of Treasuries, said Tiffany Wilding, North American economist at Pimco.
Still they are even more attractive now.
Comment
The situation here looks to be something of a perfect storm where various factors have been in play in a minor way and have been enough via convexity selling to push the market. Regular readers may have noted to have not mentioned inflation and that is simply because bond markets seem to have decoupled from that.
Moving outside of the US there are many who are directly affected by their use of US dollar borrowing. Places such as Argentina, Turkey and Ukraine come to mind but there are plenty of others. Then there are those indirectly affected by the reality that their bond markets follow the US one. So that is the UK where the ten-year yield has nudged 1% today as opposed to the 0.5% of early August. Also Germany although a ten-year yield of -0.2% shows it is being paid less to borrow rather than paying more.
These moves will ripple through mortgage markets and business lending thus tending to add to the economic slow down. Also we will see more expensive government borrowing and this is where I get off this particular wagon as I do not see them letting this happen on any scale. The central banks will be told to stop this at some point and they will “independently” decide to do so meaning their talk of interest-rate hikes is just that, talk.
Quite how we get off this particular train I am not sure but for now with government’s becoming even more control freaks they will soon step in I think. Just to be clear I do not think it is a good idea merely that they will do it.