The Looming Shortage in Government Bonds

Guest post by Norman Mogil

Ever since the 2008 financial crisis, there has been a persistent shortage of high-quality government debt. More than just a safe haven in times of financial stress--- the so-called 'flight to quality' --   the supply of  high- quality sovereign debt has been steadily shrinking. This shortage became acutely apparent with the results of the Brexit referendum as investors worldwide bid up bond prices to the point where most long term bond yields reached historic lows in the US, UK , Germany and Japan. Brexit only exacerbated a shortage problem that bond investors have had to contend with for nearly a decade. The current  squeeze in supply is just the latest manifestation of this wider issue in today's financial markets.  

To claim that there is a shortage of government debt must seem counter-intuitive to many readers. After all, there is no end of studies demonstrating that major economies have record high  government debt-to- GDP ratios, signifying that there is too much debt, not too little. Many critics call for governments everywhere to issue less debt, arguing that such high levels of debt ratios contribute to sluggish growth, if not, outright stagnation. European governments continue to exercise spending restraints and, in general, austerity is the byword throughout the industrialized world. Governments have been very reluctant to open up their coffers by issuing more debt to fund expenditures.

However, a case can be made for more government debt. In a recent article, The World Needs More U.S. Government Debt  former FOMC member, Narayana Kocherlakota  argued this case, succinctly, when he wrote:

But scarcity is not about supply alone. In the wake of the financial crisis, households and businesses are demanding more safe assets to protect themselves against sudden downturns. Similarly, regulators are requiring banks to hold more safe assets. Market prices tell us that the government needs to produce more safety in order to meet this increased demand.  ........ The inadequate provision of safe assets also has profound implications for financial stability.  Without enough Treasury bonds to go around, investors “reach for yield” by buying apparently safe securities from the private sector ...if such behavior becomes widespread, it can create systemic risks that tip the financial system into crisis.   

To better understand how bonds became scarcer, we begin by looking at who is buying government debt and why.

The Expanding Role of Central Banks

 As the Federal Reserve sought ways to stimulate the economy, it became the first major central bank to start a bond-purchase program-- Quantitative Easing (QE) Soon after the Bank of England (BoE) , the Bank of Japan (BoJ) and most recently the European Central Bank (ECB) developed their own versions of QE. ( Chart 1).  The US Fed holds nearly 20 percent of all Federal government debt;  the BoJ owns over 30 percent ; the BoE, 25 percent; and, the ECB  has so far bought about 15 percent of German debt. The Fed is no longer purchasing debt, while the other central banks continue with their QE programs. 

The Fed increased its balance sheet dramatically from about $800 billion to over $2.4 trillion under three QE programs . Although the Fed no longer actively purchases government bonds, it appears in no hurry to release those bonds into the marketplace, instead allowing the bonds to mature fully over time.   

Over 40 percent of outstanding US Treasuries are held by foreign central banks , sovereign wealth funds and other institutions.  China and Japan together account for about 12 percent. As the US runs current account deficits with its major trading partners, the excess in US  dollars are re-cycled into purchases of US Treasuries. More importantly, many central banks , especially, those in emerging countries have purchased Treasuries in increasing amounts and holding them to shore up their balance sheets and to provide needed foreign exchange reserves.  In sum, Treasuries are been soaked up by US domestic and foreign entities as part of a worldwide push to strengthen balances in the private and public sectors in the wake of the 2008 financial crisis. 

The ECB and the BoJ both continue with very aggressive bond purchasing programs. The BoE may be forced to expand its current program in response to the fallout from  UK voters opting to leave the EU. The ECB came late to the game of bond purchases, starting  in 2015, some six years after the US first implemented QE. Initially, the ECB embarked on a program of purchasing  government debt at a rate of 50 billion euros per month. But as the supply of qualified government debt diminished the ECB  increased its bond purchasing program to included corporates  . Overall, the  ECB program now soaks up about 80 billion euros a month of high quality debt . Speculation  is ripe that the ECB will do more bond purchasing in the wake of the Brexit vote.  Turning to Japan, the BoJ has long been a huge purchaser of domestic government bonds( JGBs) .Over the next four years, the BoJ is expected to own over 60 percent of all outstanding  JGBs, the highest of any country.

Growing Domestic Needs for Treasuries

Domestically, major holders of Treasuries include  Federal government and state / local  pension plans ( Table 1). These plans will require additional risk-free Treasuries to meet longer term  obligations. US charted banks have significantly increased  their holdings of Treasuries and Agency debt as a means of strengthening their balance sheets. From 2013 to the present , commercial banks increased holdings of Treasuries by 30 percent .Finally, private pension funds and the life insurance  companies hold approximately 6 percent of  their assets in Treasuries. Industry analysts argue that  proportion is inadequate to meet future liabilities and it is expected that these institutions need to double their holdings to satisfy future income requirements. In short, government bonds will be a strong asset class from here on out as these institutions re-balance their portfolios to meet long run requirements. 

The Phenomenon of Negative Interest Rates

One does not have to look any further than the  exploding  market for negative interest rate bonds to find convincing  proof of a bond shortage . Today negative interest rate  bonds total over $US12 trillion in Europe and Japan ( Chart 2). More importantly, the average duration of these bonds has increased remarkably just within the past year.  Negative yields extend out to 10+ years in Germany, 15 years in Japan and even as far as 30 years in Switzerland . ( http://soberlook.com/2016/04/understanding-negative-interest-rates.html) 

Not surprisingly, central banks themselves are having trouble finding all the bonds they need. For example ,the ECB  is not permitted to buy bonds with a yield lower than its deposit rate of minus 0.4 percent, thus excluding many billions of euro-dominated bonds issued by Switzerland, Germany, France , Netherlands and Sweden. In other words, there is a real squeeze on positive-yielding safe haven bonds.  

  Vanishing Credit Quality and Liquidity  

Since the emergence of the debt crisis in Europe starting in 2012, there has been a wave of  national debt downgrades .The Bank of America Merrill Lynch estimates that the share of bonds with the three highest credit ratings has dropped to 51percent of all debt tracked by the bank’s world sovereign bond index from 84 percent in 2011. With so many institutions restricted from purchasing anything less than high quality bonds, managers are facing a smaller and smaller market in which to participate.  Credit worthiness comes into play in the very large repo loan market where high quality debt is used as short term collateral by hedge funds,  money markets, private equity and other lending groups. It is estimated that the volume of repo loans using Treasury debt has nearly halved since the financial crisis of 2008. 

On the issue of liquidity,  there have been system wide reductions, even in the case of the US Treasury market, considered to the most liquid of all bond markets. Regulatory changes post-2008 have made bond dealers less willing to hold inventory and facilitate trades. Bond trading desks have slashed inventories in response to regulations such as Basel III and the Volcker Rule.  Hence, primary dealers have reduced their U.S. debt holdings by as much as 80 percent according to Bloomberg. com estimates. 

These liquidity developments have prompted Barry Eichengreen of  UC Berkeley to  argue that ``international liquidity has plummeted from nearly 60 percent of global GDP in 2009 to barely 30 percent today.`. Recent auctions for US Treasuries feature large oversubscriptions, and this has driven yields lower. There is more than just a temporary flight to safety to quality debt; there appears to be a major shift in asset preference in favour of high-quality debt issued by the US and other major countries at a time when the supply of that debt is not keeping with demand.

Outlook for Supply  

In a recent report , Bank of America Merrill Lynch  said that  "the world is running out of positive-yielding safe-haven bonds’’. The looming shortage has implications in many segments of the fixed  income market. Every indication points to a worsening of the supply shortage of high quality bonds. In the US, the 2016  Federal deficit  is expected to be lower than the  previous year by some 25 percent.  To finance this lower deficit, the Treasury has opted to issue more bills instead of bonds as a means of lowering interest costs .This combination will exacerbate the shortage situation and will most likely keep long rates down at these current levels.

In Europe, the ECB is running out of qualified government bonds to purchase in the wake of a growing segment of the market having gone deep into negative territory. It has had to resort to buying corporate bonds to satisfy its purchasing objectives.  There is no sign that Euroland will ease up on its austerity program and we can expect a tight supply of new government issuance in 2016-17.  Japan continues to wallow in deflation and  the BoJ is continues to be under pressure to step up its bond purchasing program, driving longer dated yields ever lower. From a supply perspective alone, we can expect that long term rates will  be kept at these historic low levels.

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Expect higher treasury yields in second half

While many investors refuse to accept this fact, we are clearly marching toward higher treasury yields later in the year and in 2015. Even after today's bond selloff, we are still around the yield levels we had during the dark days of the government shutdown. Here are a couple of key factors that will drive yields higher from here.

1. Many are pointing to record low yields in Europe (see chart), suggesting that on a relative basis treasuries look attractive. Perhaps. But it's important to make that comparison based on real rates rather than nominal. And given the disinflationary environment in the Eurozone (see chart), a significant rate differential between the US and the Eurozone is justified. After all, we've had a tremendous differential in nominal yields between the US and Japan for years. Furthermore, economic growth (and expectations for growth) in the euro area and in the US have diverged significantly (see chart). Today's US GDP report confirmed that trend.

2. The net supply of treasuries is not static. In particular when it comes to treasury notes and bonds (excluding bills), the Fed has been the dominant buyer (see chart). With the Fed tapering, the net supply is expected to rise.

Source: JPMorgan

Foreign buying of notes and bonds has declined and is not expected to replace the Fed's taper. It will be primarily driven by China's rising foreign reserves. But given declining support from the Fed, China is likely to make bills (vs. notes and bonds) a larger portion of its purchases. And bill purchases will have a limited impact on longer dated treasury yields.

To be sure, we are going to have plenty of demand for treasuries going forward. But given such a spike in supply and improved growth expectations, something on the order of 50-75 basis points increase in the 10-year yield in the near-term is not unreasonable. 

It is also worth pointing out that with the dealers remaining cautious holding significant inventory and the Fed out of the picture, higher volatility in treasuries becomes more likely.


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From our sponsor:

6 reasons treasury yields should be higher

It remains difficult to reconcile treasuries trading at the same yields we saw during the US government shutdown (see post) with broadly stronger economic conditions in the US. Economic indicators suggest yields should be materially above the lows we saw last October. Here are some of the key trends:

1. Leading indices are all stronger - ECRI is at pre-recession levels.

Source: Economic Cycle Research Institute

2. Labor markets are clearly improving. Initial jobless claims clocked below the 2006 level this week (see Twitter post).

Source: Gallup

3. Small business surveys show owner sentiment, which had remained weak for years, finally on the rise.

4. Credit expansion in the US has accelerated.

5. Inflation is picking up (see post) and inflation expectations are higher as well.

5y breakeven inflation expectations (Ycharts)

6. And even the housing market, which had stalled this year, surprised to the upside today. Both housing starts and permits came in above expectations.

Source: Investing.com

Clearly there are geopolitical tensions over the Ukraine crisis and all the search for yield in the face of the ECB's expected easing action is putting downward pressure on rates globally. The US consumer remains jittery, generating a drag on growth. Furthermore, equity investors are using treasuries as a proven form of downside protection. Yet in the face of strengthening economy and relative to the uncertainty of the US government shutdown and debt ceiling impasse last year, current low yields are difficult to understand.

SoberLook.com

From our sponsor:

When was the last time treasury yields were this low?

We've had an unprecedented compression in US (and global) government bond yields in a short period of time. Here is one surprising fact: Treasury yields are now at the level they were during the US government shutdown. The level of uncertainty has diminished dramatically since then and the employment picture continues to improve (see Twitter post). Yet here we are again. This time however it's the global chase for yield and expectations of ECB's monetary easing driving rates to new lows.

Source: Investing.com

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From our sponsor:

Survey results

Here are the survey results from the post on Friday's market action in treasuries (see post).

Below are some of the "other" reasons the survey participants pointed out:

• many tactical shorts that have been squeezed, may be some shorts throwing the towel
• QE taper end always sees bonds rally
• Equity market risk
• Price action: Trend followers who missed the move so far saw a good entry point to get long
• players realize dire circumstances EM are in and that Fed has no choice but to quash rates through 2020 and maybe beyond - see Levy reference in Barron's by Forsyth this week
• deflation; payrolls are a lagging indicator
• US 10-y yield attractive at 1.8 times Bund 10-y, or versus JGB 10-y
• Slowing global growth
• no inflationary pressure, real yields at the long end are very compelling
• Unwind of risk on trade because of tapering.
• growing awareness that the "neutral" policy rate is low

Apologies if your "other" response wan't included - there were just too many to list.

SoberLook.com

From our sponsor:

Friday's surprising treasury rally

Many were surprised by the strength of the US April payrolls report yesterday.

Source: Investing.com

However this should not have been a surprise. As discussed here and here, the signals pointing to US labor markets strengthening were there all along - some simply chose to keep the blinders on. The real surprise was the bond market reaction. Longer-dated treasuries sold off and rallied right back shortly after.

10y note futures contract (source: Investing.com)

When the dust settled, the treasury curve ended up considerably flatter vs. the prior close.

Why? There seem to be countless explanations and none seem to be particularly satisfactory. Here are a few:

1. Some view last month's drop in labor force participation as a sign of weakness in the labor markets. Clearly participation is an issue, but this is nothing new. The unemployment rate dropped to 6.3% as hundreds of thousands of people lost their unemployment benefits - an effect that was in fact predicted a while back (see Twitter post). It doesn't change the fact that 288K of new payrolls were created.

2. Average hourly earnings came in below expectations, potentially pointing to the lack of near-term wage pressures. Once again, while it is not a great outcome, this measure tends to be highly volatile and does not detract from the strong payrolls number.

Source: Investing.com

3. The steepener trade unwind? Some have argued that the market was positioned for the curve to steepen and the employment report forced an unwind. The pressure to exit the steepener trade would have come from the Fed rate hikes being brought forward, putting downward pressure on the intermediate maturity bonds. Perhaps.

4. A major international buyer (potentially buying for an official account) is focusing on longer dated government bonds that still have some yield - not just in the US but across the developed markets (more on this later). While a real possibility, it's unclear why this is taking place now.

5. Geopolitical risks associated with Ukraine make treasuries a safe haven investment. This seems to be a more plausible explanation, especially given the fact that gold also gained 1.3% for the day.

We would like to get the readers' views on this issue. Please select one of the 5 possibilities listed above or add your own in this survey question. The survey results will be published shortly.

SoberLook.com

From our sponsor:

Don't bet on treasury rally to continue

Treasuries rallied sharply last week, mostly on the back of the sell-off in equities as well as in response to the Fed's seeming backpedaling on the timing of rate hikes.

10y Treasury Note Futures (source: Investing.com)

While the equity market pullback makes sense for a number of reasons (including increased leverage and momentum driven activity in a number of shares), the treasury market rally does not. Reading the dovish tea leaves of the FOMC minutes is counterproductive. The Fed's reluctance (see story) to support its own FOMC members' projections of higher rates by the middle of next year - which are quite realistic - simply serves to confuse the market. It's about time the Fed realizes that the US economy can withstand (and in fact could benefit from) higher rates.

Scotiabank: - We think rate hikes next year are a reasonable thing to expect and that the forecast pace is not unreasonable. Indeed, quite frankly, neither do the majority of FOMC officials themselves. Recall that the projections of FOMC officials became more hawkish at the March 19th FOMC meeting when more Fed officials (10 of 16) projected that the Fed funds target would equal 1% or more by the end of next year. This is reflected in chart 2 which is a recreated version of the Fed’s famous dot plot that shows the fed funds target forecasts of individual FOMC officials. Presumably not all 10 of those individuals think that higher rates will commence late in the year and are more spread out in their forecasts, thus making hikes starting in Q2 or Q3 eminently reasonable. More officials also projected a Fed funds target of 2% or greater by the end of 2016 (12 of 16).

It can't be both ways by way of talking down the risk of rate hikes while still forecasting them. Suppressing yields in the short-term only aggravates the potential for disruptive market behavior later. The Fed either has a forecast to which the balance of Fed officials are committed, or it doesn’t. I might not have views identical to those of all of my bright, ambitious colleagues surrounding me, and thus emphasize different risks to a house view. But conducting policy gives each individual one vote and that weighted perspective on Fed views is turning more hawkish, full stop and regardless of attempts by the Fed’s communications subcommittee to massage the market outcome.

The big debate among the FOMC members has been around the amount of slack in US labor markets. The focus has been on falling labor force participation which is to some extent due demographics.

Wells Fargo: - Compared to previous decades, cyclical factors have played a larger role in the path of the participation rate in recent years as labor market weakness continues to keep some potential job seekers from looking for jobs. However, the participation rate began to decline in 2001, well ahead of the recession, amid demographic and cultural shifts independent of the business cycle. The secular forces of higher female participation and the baby boomers entering their prime working years that led to a four-decade long rise in labor force participation have now reversed. Female participation peaked in 1999, and in 2001 the first of the baby boomers turned 55 years old—an age at which participation begins to decline notably. We find that demographics alone have accounted for about half of the decline in the labor force participation rate since 2007.

The reality is that as the headline unemployment figures continue to improve and wages begin to pick up, the Fed will be forced to hike rates in spite of weaker labor force participation. And key US employment metrics clearly point to ongoing improvement.

Gallup's Job Creation Index

For those who have been jumping back into treasuries as a result of the Fed's perceived dovish stance or as a hedge to equities, be prepared for a disappointment.

Barclays Research: - At current levels, we believe outright short duration offers a good risk reward as well. The market has gone too far in discounting the move higher in the “dots” [individual members' forecasts for higher rates] at the FOMC, which was largely driven by an improving outlook of the labor market.

SoberLook.com

From our sponsor:

5-year treasury cheapest in years after selloff

The five-year treasury yield hit a multi-year high relative to the average of the two- and the ten-year rates (the 5-year treasury is cheap on a relative basis). The chart below shows a measure of how "concave" the treasury curve has been over time (negative indicates the curve is convex).

2 x (5yr yield) - (10yr yield) - (2yr yield) 

Given that the five-year tenor is sensitive to the trajectory of the Fed's rate policy in the intermediate term, this is where we should see quite a bit of volatility (see post).  We've come a long way from the days when the 5-year treasury was highly overpriced relative to the rest of the curve (see story from 2012) and the market was pricing in "perpetual" QE.

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From our sponsor:

Shifting focus in the treasury markets

Treasuries once again experienced what amounts to a sharp curve flattening in recent days. The market action resembled what took place after the initial announcement of taper back in December (see post). The yields in the "belly" of the curve have risen sharply as the market prepares for rate "normalization".

Treasury yield moves from close of 3/7/2014 to close of 3/21/2014

MarketWatch: - The yield curve’s violent reaction to the Federal Reserve on Wednesday shouldn’t be thought of as a first-day fluke by Chairwoman Janet Yellen. Rather, the rise of intermediate-term Treasury yields is one step in a monetary policy normalization process that will characterize the rest of the year, according to mammoth investment management firm BlackRock.

If last year was all about longer-duration Treasury yields moving higher — the 10-year Treasury yield rose more than a full percentage point and now trades at 2.78% – this year is all about the rise at the front end of the curve, according to Rick Rieder, chief investment officer of Fundamental Fixed Income for BlackRock.

“I think this is a very different year for managing fixed income,” he said in a press briefing Thursday.

The MarketWatch article proceeds to describe in detail how rates had moved this year vs. last year. It all however comes down to a single chart which shows daily treasury yield volatility across the curve this vs. last year. A picture is worth, well you know...

Market focus is shifting from taper to the near-term trajectory of the overnight rates, which is impacting the intermediate and shorter maturities. The first rate hike, while still some time away, is becoming a reality.

SoberLook.com

From our sponsor:

Market correlations shift back to risk-on/off pattern

The chart below compares the performance of long-term treasuries (TLO) to emerging market bonds (EMB) over the past year.

Source: Ycharts

The relationship between US rates and emerging market assets (particularly bonds and currencies) has shifted. Last year both were responding the big unknown of the Fed's tapering of QE3 - and moving roughly in the same direction. Now that taper is a reality and we have some certainty around the magnitude of the reductions in the near-term, the correlation has reversed. The current environment is once again based on risk-on/risk-off dynamics as was the case during the Eurozone crisis. Risk-on pushes prices of treasuries higher and emerging market assets lower. This trend that was quite visible yesterday, with a partial reversal taking place today (chart below compares Brazil vs. US rates in recent weeks).

SoberLook.com

From our sponsor:

Fed's taper and weaker foreign participation will leave domestic investors with higher proportion of treasury purchases

In a couple of earlier discussions (here and here) we talked about a significant buildup of treasury short positions. Since then there are indications that a few of the larger direct players have been covering their short bond exposure, pushing treasury yields lower. If the emerging markets contagion (discussed here) persists, more short covering is expected.

But what about the longer-term outlook for treasuries? As the Fed cuts its buying program, we are left with two major categories of purchasers - foreign and private domestic. Foreign buying is directly linked to growth in current account surplus of key US trading partners, particularly in Asia. And while nations like China and Japan hold enormous amounts of US government paper, it's unclear if they will return to the volumes of purchases from 5 years ago. For example the explosive growth in China's current account surplus through 2009 is no longer there, which should translate to a more modest rate of treasury buying.

Other emerging economies are not faring much better and in fact many are struggling to maintain export growth. As a result fewer dollars on a relative basis will be available to buy treasuries.

The other group of foreigners who have been buying significant amounts of treasuries are the oil exporters. In fact some research links growth in the so-called "petrodollars" (proceeds from energy sales) to higher treasury purchases. But as the US reliance of foreign oil declines, fewer petrodollars should result in relatively smaller purchases of US bonds.

This means that foreign purchases of treasuries are unlikely to grow significantly from current levels. That leaves US domestic investors to pick up the slack left behind by the Fed and foreign buyers. Based on the projections from Sandler O’Neill, domestic buyers will be called upon to buy an increasingly larger share of government paper going forward.

Source: Sandler O’Neill (click to enlarge)

Rising yields in the intermediate and possibly longer term is an inevitability - the only way to attract domestic buyers to this growing supply.

Sandler O'Neill: - In light blue [in reference to chart above] we see the episodic role of foreign purchases, driven heavily by emerging markets’ swelling reserves as trade and current account surpluses exploded until 2006, followed by industrial market buying to escape several phases of the euro crisis. Contemplating the chart carefully. domestic private purchases in dark blue must now take up substantial net demand slack.  ... domestic private buying (retail and institutional) must essentially quintuple back to their levels during the financial crisis. This seems unlikely without additional yield

And it's not just the longer term rates that will increase as the result of this shift to private domestic buyers. Sandler O'Neill points out that as the longer term rates rise, the Fed will be forced to raise the overnight rate. This may end up being less about the US employment situation and more about keeping the yield curve "steepness" (see post) from becoming extreme. One of the reasons short term rate adjustment will be an  imperative is the risk of a new buildup in the so-called carry trade.

Sandler O'Neill: - This also leaves a quandary for short term interest rate policy. Should the 10-Year reach 4%, the spread over Fed Funds will be confronting its well-defined historical peak. In our view, the Fed would be highly likely to adjust the policy rate upwards in this situation to avoid further market distortions and a potential explosion in carry trade and other counterproductive rate arbitrage activity. If this is correct, short term interest rates might no longer be simply anchored to employment metrics.

The Fed's taper, combined with weaker foreign purchases of treasuries, will leave private domestic investors to take on an increasingly larger portion of treasury purchases. The only way to attract more domestic buyers is with higher yields - which will ultimately result in rising rates across the curve.

SoberLook.com

From our sponsor:

Bond bears seem overextended

Directional investors/traders remain heavily short or under-invested in the bond market. For example the CFTC commitment of traders shows speculative investors, particularly the smaller ones, being quite short the 10y note futures.

Source: Barchart (thousands)
"Comm" stands for "commercial" futures participants, such as dealers who use futures to hedge their positions

Institutional investors are also heavily under-invested in bonds. The so-called "real money", such as pensions, endowments and insurance firms were overweight duration (holding higher bond positions than their targeted allocations) when yields were the lowest (back in 2012). Now with higher yields, these same investors (after being whipsawed by the market) are running duration levels that are the lowest since 2008.

Source: DB

These technical factors should provide some support to treasuries in the near term in spite of the Fed's taper - particularly if the equity market does not perform as well as many are expecting. 

SoberLook

From our sponsor:

Today's jobs report: a wake-up call or an aberration?

Today's payrolls shocker (see story) sent treasury yields sharply lower. As discussed last month (see post), speculative investors have piled into the market and were forced to cover their shorts after the jobs report. Going forward, until there is more visibility on the labor markets, investors will be more cautious shorting treasuries.

The shape of the treasury curve move has become fairly predictable, with the "belly" experiencing the largest moves (see post).

Now comes the debate on whether this jobs report was a fluke.

LA Times: - Analysts were shocked by Friday's Labor Department report that the economy added just 74,000 net new jobs in December, about one-third what many had forecast. The bad weather in parts of the country last month apparently played a role, and there were unusually big payroll drops in the movie industry and at accounting firms.

Still, that doesn't fully explain why the hiring was so weak. The healthcare sector was flat, as was transportation and warehousing, for example. On the whole, job growth was not only the lowest in almost three years, it was incongruous with the latest string of positive economic data -- on exports, homebuilding, consumer spending -- indicating an economy and job market gathering steam.

Is this a wake-up call on more weakness in the US labor markets or simply an aberration? Thoughts, comments?

SoberLook.com

From our sponsor:

Is the treasury market oversold?

When it comes to treasuries, there is no shortage of bearish news. The budget deal is done, the third quarter GDP was better than expected (inventory build issue aside), and the US labor markets are supposedly getting better. Expectations of an "early taper" are running high, with the Fed poised to pull the trigger on cutting back securities purchases sooner than was originally thought. Moreover, bond funds outflows continue, with many investors dumping anything that has a fixed coupon. And if the fundamentals aren't bad enough, technicals for treasuries look terrible as well. Moving averages and other technical indicators are all screaming "sell".

Based on daily trend (source: Investing.com)

That's precisely what many investors have been doing since October, as treasuries resumed the decline which began last spring.

Source: Investing.com

Now consider the following chart. It shows the aggregate speculate investor positioning in dollar rate-sensitive futures. The measure is duration weighted, assigning a higher weight to the 10y note futures than to bill futures for example.

Source: Credit Suisse

This tells us that "speculative" investors are building up what amounts to a large (relative to recent history) short treasuries position. And why not - so far all signs have pointed to this being the right trade. Until some of these trigger-happy traders begin to cover.

With all the bearish news out and everyone - including retail investors - talking about rising rates, the contrarian view would put the near-term risk in treasuries to the upside.

SoberLook.com

From our sponsor:

"Radioactive" treasury bonds: the "least unconstitutional" path?

The Gallop sentiment index is now at the lowest level since 2011, when doubts about Italy's ability to roll its debt posed risks to EMU's stability. It took the first 3-year LTRO program to bring some calm to the markets and to consumer sentiment. Now, in a matter of days we are back to those lows again.

This is a serious blow to the US economy, with the full damage becoming visible in months to come. While there isn't much that can be done about the shutdown without some sort of a deal, academics have been desperately searching for a solution to what amounts to a constitutional crisis - the debt ceiling impasse. One such proposal came from Columbia University (Neil Buchanan and Michael Dorf).

The authors argue that the executive branch is presented with two competing directives. The Obama administration is required to spend money on programs appropriated by Congress (including paying on government debt, paying for Social Security, Medicare, etc.). At the same time the president is not allowed to issue incremental debt. Complying with both is an impossibility, forcing the president to violate the constitution one way or another. The two Columbia law professors argue that in such a situation the president should choose the "least unconstitutional" path. And that would be issuing additional debt without the approval from Congress (see paper below).

The problem with this solution is the market. Selling "unconstitutional" treasuries will encourage traders to short these bonds against older (constitutional) vintages. Inevitably someone will challenge the paper's constitutionality - potentially all the way to the Supreme Court. In the mean time yields on such paper may end up being quite high. Ultimately it will push up rates across the board as more of these bonds hit the market. Such a scenario could make the Fed's "taper" feel like child's play. The authors call these bonds "radioactive" and admit this solution could be problematic. Nevertheless they argue it is better than an outright default and could potentially pacify the markets.

It took the 3-year LTRO to calm global markets in 2011. Now we talking about "radioactive" bonds to help us do the same in 2013?

Enjoy!
Columbia Law Review

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HY spreads now positively correlated to treasury yields

Here is further evidence that in this environment treasuries are driving "risk asset" valuations. Corporate HY bond spreads are now positively correlated to treasury yields. That's quite unusual because traditionally when treasury yields shrink, spreads rise (negative correlation).

Based on Merrill HY Index

By not allowing treasury yields to rise, the Fed is artificially suppressing HY spreads (as well as other "risky" bond spreads). The corporate market is therefore heavily dependent on stimulus, making any attempt to normalize monetary policy increasingly difficult.

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What caused the belly of the treasury curve to become more volatile?

While yields on treasury notes and bonds have risen across the board in 2013, the jump in rates has been uneven. The 5-10-year rates - the "belly" of the curve - have increased materially more than other maturities.

Furthermore, the volatility of rates across the different maturities has also been exhibiting a similar pattern, with the yields in the belly of the curve becoming substantially more volatile.

But it hasn't always been this way. The chart below shows how the 7, 10, and 30-year volatility evolved over time.

There was an inflection period early this summer, when the 7-year yield volatility spiked above all the rest. What caused this adjustment? Some of this of course is the selloff related to the Fed's treasury holdings. With fewer purchases of certain bonds, the demand is expected to decline, pushing yields higher.

But there is another explanation. Back in June we discussed the so-called "convexity hedging" (see post). When rates began to rise, MBS durations extended, as mortgage refinancing slowed. And as rates kept increasing, higher coupon MBS became more vulnerable to extension risk. Those with a 4.75% mortgage could still refinance earlier in the summer, but the window on that mortgage closed quickly. MBS holders who saw no need to hedge in the past couple of years had to start shorting treasuries to match their increasing portfolio durations. And intermediate-term treasuries have been the choice hedging instrument. Note that a 30-year treasury is not a good hedge for a 30-year mortgage because the probability of homeowners holding on to their mortgage to maturity is quite low - a shorter instrument is therefore required.

The spike in MBS volatility early in the summer (chart below) increased hedging activity, disproportionately raising the volatility (and yields) of the belly of the treasury curve. This hedging is what created the inflection in the chart above.

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Market regime change - is your risk manager even aware of it?

Rising rates should be good for a currency. At least that's the theory. And those who believe it have been disappointed in the last few years, because just the opposite has been true. Since the financial crisis, both the dollar and treasuries have been viewed as "risk-off" assets. When it felt as though the next Eurozone country was about to fail, investors bought treasuries and the dollar. Each dollar rally would typically coincide with stronger treasury prices and lower rates. The dollar-to-interest-rate correlation became more negative as things in Europe became more uncertain. The correlation hit its lowest level (most negative) after Italy's ability to fund its government and the whole of EMU's future was brought into question in late 2011.

But recently we've had what some refer to as a "regime change". Treasuries to some extent lost their status as a "risk-off" asset (see post). The correlation between the dollar and interest rates suddenly flipped into positive territory, which is more in line with the traditional way of thinking about the relationship. In fact the correlation hit its highest level in nearly a decade. US rates recently became the "risk driver" of other asset classes.

Trade Weighted U.S. Dollar Index: Major Currencies (DTWEXM) vs. 10 yr  treasury yield

This regime change plays havoc with many common risk models that banks and even some asset management firms run. These models often drive trading limits, counterparty potential exposure measurements, and bank regulatory capital. The calculations tend to rely on historical relationships - sometimes over a period covering the previous two years (as prescribed by the Basel rules). At this point however some of these models are all but meaningless, as correlations among major asset classes have flipped. Yet these measures continue to be broadly used, with regulators encouraging or even requiring this practice.

So the next time you see a "value at risk" measure, ask the author how she/he addressed the recent regime change in the markets. The answer may surprise you.

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Putting recent treasury losses in perspective

The histogram below shows the total return of long-dated treasuries over a rolling 4-month period since 2007. The rationale for using a 4-month period is that the climb in long-term rates started 4 months ago (a 3-month period produces a very similar result.) The leftmost bucket contains five periods that constitute the worst treasury losses since 2007. All five of these periods ended within the past 10 days, indicating that the recent losses are the worst in at least 6 years.

For those who have access to this index on a total-return basis going back further that 2007, it would be interesting to see how far back one actually has to look to find an equivalent correction to bond prices.

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Speculative treasury positions are now net short and growing

Speculative money has become visibly short rate products. As discussed this weekend (see post) there still seems to be a broad bearish sentiment on treasuries - in spite of the massive selloff. The charts below show speculative net positions in LIBOR futures ("ED") and the 10yr note futures ("10s"). LIBOR futures are often uses to take a speculative view on long-term interest rates (usually via a "strip" of futures extending out a number of years - effectively mimicking a rate swap). The 10yr note future is the most common way of betting on rates in the futures market.

In the last couple of months positions flipped from net long to net short. If the economy or the Fed were to disappoint, the resulting treasury rally could prove painful for these investors.

Source: JPMorgan

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