Treasure the Treasury Bond

There has obviously been quite a lot of chat about whether there is a bond bubble, but much of this has focused on the supply side of the equation. Evidently, with trillion-dollar deficits in the US and the increasing fiscal costs of bank bail-outs in many Western countries, many are wary of the ability of governments to issue debt to fund these rescues, as witnessed with the dramatic widening in EMU bond spreads and sovereign CDS. But what about the demand side? Firstly, various implementations of the Taylor rule argue for a Fed Funds rate that is significantly negative. With the output gap being so wide there is a clear case that bonds are undervalued, and although extrapolating historical relationships is always risky, bond yields have traditionally not bottomed until the output gap has peaked, and the Fed has not begun tightening monetary policy until the Unemployment rate has peaked (there is certainly a political aspect to this). In such an environment, bonds are likely to be supported.

Secondly, in both the Great Depression and in Japan's Great Recession, the explosion of government deficits did not result in higher bond yields. And, of course, the question is "Why not?". For this, I highly recommend reading "The Holy Grail of Macroeconomics: Japan's Great Recession" (http://astore.amazon.co.uk/breakingviews-21/detail/0470823879) by Nomura's Richard Koo who is arguably the expert on all things to do with Balance Sheet recessions, and Japan's in particular. The basic crux of his argument is that when faced with weak or decimated balance sheets, the private sector ceases to maximise profit, and instead concentrates on paying down debt and repairing its balance sheet. Under such a scenario, private demand for credit collapses and, as a result, domestic credit contracts regardless of the monetary policy that the central bank follows (it does not matter what the cost of funds is if no-one wants to borrow them).

Textbook economics suggests that increases in the monetary base lead to increases in M2 and then to increases in domestic credit via the money multiplier. In the below chart of Japan's experiences, in the late 1980s these three measures grew in tandem until mid-1991 (white vertical line) when policy became too tight and monetary base shrunk and faced with the rising cost of borrowing in the bond market, corporates ramped up their borrowing from banks. When the BoJ finally began to ease, it was too late, and in late 1992 (red vertical line) corporate behaviour changed, and firms began to pay down debt as they realised that their balance sheets had been decimated, leading to a contraction of domestic credit (green line) which continued to shrink until 2005 despite the significant growth in the money supply under QE. Clearly, firms were not interested in borrowing, and thus the very large fiscal stimulae the government enacted throughout the stagnation did not result in inflationary pressure because there was no crowding out of the private sector. This also explains to some extent why QE was not particularly successful in stimulating investment. The corollary to this is that the private sector posted a financial surplus as debt was paid down, resulting in a net inflow of cash into the banking system. In the absense of demand for loans, the banks faced no alternative but to park the money in JGBs - the government was the only entity willing to borrow to invest, and thus was effectively funded by depositors.

And this is what I think is key for the US, UK etc. Rather than being primarily a corporate issue as in Japan (ok, households were also severely affected, but the main problem was corporates), the Western crisis is primarily a household balance sheet issue (in the aftermath of the DotCom bust, firms repaired their balance sheets and generally entered this downturn with reasonable interest coverage from earnings). Faced with negative equity (or the potential to be in negative equity) consumer credit has begun to fall, and with it, consumption has collapsed. The below chart shows the US equivalent of the above Japan chart. As is well-known, the Federal Reserve has ballooned its balance sheet (as illustrated by the jump in the monetary base - red line) and as a result, M2 has begun to accelerate too, but consumer credit (yellow line) has begun to fall as demand for credit from households is falling:The Fed's Senior Loan Officer survey is also showing evidence of this, and the recent credit crunch appears to have been masking this effect:

The credit boom induced commercial banks to reduce their share of holdings of US Treasuries to a record low, but as in past recessions, this fraction tends to increase naturally. However, with households on course to dramatically increase their savings rate and pay down debt, this financial surplus is ever more likely to end up parked in Treasuries. As the below chart suggests, there is no reason why Commercial bank holdings cannot increase to around 20% of outstanding public debt (c.f. China holds ~12%), which provides additional demand of over $1trn.
In conclusion, while there are likely to be occasions when the market gets excited about a turn-up in the data (and eventual recovery), until the output gap peaks, bonds are a buy on dips. The fiscal stimulus is likely to provide such a dip as Q2 GDP is likely to print ~2.5%, and lead the market to price in a false V-shaped recovery, similarly to last spring. Crucially, the above argument does *not* rely on Fed purchases of USTs to create incremental demand (as the market seems to have got itself into a tizz about) - the demand will come from commercial banks themselves.

EMU Bail-out?

Recent comments by German Finance Minister Steinbrueck (http://www.bloomberg.com/apps/news?pid=20601110&sid=ax0ZrocriLAI) have garnered some attention as yet another European-about-turn, suggesting that Germany and France may have to come to the assistance of EU nations in trouble. In recent weeks, EMU CDS and Bond spreads have blown out significantly, to the point that Ireland 5yr CDS (at 400bps) now prices a Cumulative Default Rate of around 20%. Ireland's poor domestic fundamentals are well-known.

I have heard many anecdotes that trading in Western Sovereign CDS has exploded over the past few weeks as Macro hedge funds have jumped onto these trades, which are effectively like a synthetic run on a currency (if these countries had their own currency, that is). It reminds me a lot of the moves in Bank/Broker CDS in March 2008 as hedge funds forced a run on Bear Stearns, and immediately after began to target other banks (e.g Lehman, Merrill etc) after the bondholders were protected but equity holders were effectively wiped out. Government actions effectively provided hedge funds with a precedent, so they jumped onto the next victims.

I bring this up, because I think it is increasingly likely that Ireland will be bailed out, one way or another, in the very near future (possibly as early as this weekend) - even though the Sovereign CDS market is extremely illiquid and probably not a "real" gauge of the market's view of peripheral countries' strength, it is creating such a perception - amplified by media reporting - and has also translated into wider government bond spreads in the cash market. Such actions can demonstrably change the behaviour of both individuals and the market as a whole, forcing the issue and demanding a policy response. I believe that we have reached such a point that action needs to be taken, and Steinbreuck's comments suggest that EU policymakers agree.

Such action is likely to be merely symbolic, at least initially, perhaps involving the Bundesbank being directed to purchase a token amount of Irish Government Bonds in the open market. The problem with this - as seen with the Fed's purchases of MBS - is that to be credible, "significant" amounts of bonds needs to be purchased. However, with the Germans implicitly backing Irish sovereign debt, it is likely that there will be a rush for the door in the CDS market (similar to that in the aftermath of the sale of Bear Stearns). But with a precedent set that Germany will bail-out peripheral EMU nations, the market will begin to gun for other countries, likely targeting Spain, Austria, Italy et al. The obvious question is "where does it end?". There are German elections this year, and given the hardened public opposition to even domestic bail-outs or fiscal stimulus, it seems extremely unlikely that such a move (or succession, thereof) would be tolerated, and inevitable that this becomes a serious political issue.

Secondly, how should we trade such an announcement? The market is well aware of the above (and this is, in part, one of the reasons why the Euro has been under pressure of late), and will likely question the sustainability of such a bail-out policy, and consequently, the existance of the single unit itself. So sell the Euro on the announcement. But what about the adjustments required to regain competitiveness? The below chart shows a few REERs of EMU countries (based upon labour costs) relative to the Eurozone as a whole vs the levels at which they entered the Euro. I couldn't be bothered to do seasonal adjustments, but you can still see the broad trends: the ESP is about 35% overvalued relative to the DEM, the IEP is about 40% overvalued relative to the DEM and interestingly (and contrary to common wisdom), the ITL is about fairly valued with respect to the DEM.

There are some significant misalignments that clearly have to be rectified one way or another to reduce the magnitude of the area's current account deficits (Spain's is as large as 10% of GDP!). Specifically, the likelyhood of leaving the Euro is extremely low - even if the FX market begins to price in this probability - so this adjustment cannot be gained externally via default & depreciation. In which case, the domestic economies must undergo deflation in a similar manner to Latvia (which appears so far to be maintaining its peg to the Euro relatively credibly), which means that growth is going to crushed, making such trades as long DAX vs short IBEX potential winners (the spike in the chart below was the VW/Porsche hedge fund squeeze). Of course, policies designed to ensure fiscal restraint and crush domestic consumption are likely to result in significant social unrest (as we have already seen in Greece), and is likely to add to market fears.