One-month Treasury bill rates ended the week at 13 bps and three-month bills closed at 14 bps. Two-year government yields declined 4 bps to 0.47%. Five-year T-note yields sank 9 bps to 1.43%. Ten-year yields declined 9 bps to 2.82%. Long bond yields added one basis point to 4.00%. Benchmark Fannie MBS yields jumped 12 bps to 3.56%. The spread between 10-year Treasury yields and benchmark MBS yields widened a notable 21 bps to 74 bps. Agency 10-yr debt spreads were little changed at 18 bps. The implied yield on December 2010 eurodollar futures was little changed at 0.44%. The 10-year dollar swap spread increased 2 to 0.75. The 30-year swap spread declined 2 to negative 29.5. Corporate bond spreads continued to narrow. An index of investment grade spreads narrowed 2 to 102 bps. An index of junk bond spread narrowed 18 to 538 bps.
Debt issuance began August with a flurry. Investment grade issuers included Metlife $3.0bn, Citigroup $2.5bn, IBM $1.5bn, Pride International $1.2bn, Altria Group $1.0bn, Omnicom Group $1.0bn, AFLAC $750 million, PNC $750 million, Expedia $750 million, Corning $700 million, Newell Rubbermaid $550 million, Northern States Power $500 million, CNA Financial $500 million, Magellan Midstream $300 million, AMB Property $300 million, and Public Service E&G $250 million.
Junk issuers included Mylan $1.0bn, Continental Airlines $800 million, Petrohawk Energy $825 million, Marina District $800 million, Tenet Healthcare $600 million, Arch Coal $500 million, Trilogy International $370 million, Energy Solutions $300 million, and Ferro $250 million.
Convert issuers included Teleflex $400 million.
International dollar debt sales included Arcelormittal $3.5bn, HSBC $3.25bn, Credit Suisse $2.0bn, Volkswagen $1.75bn, Intesa Sanpaolo $1.0bn, Tech Resources $750 million, Stats Chippac $600 million, Australia & New Zealand Bank $1.5bn, Macquarie Group $500 million, and ENAP $500 million.
U.K. 10-year gilt yields dropped 10 bps to 3.22%, and German bund yields sank 15 bps to 2.52%. Greek 10-year bond yields fell 14 bps to 10.15%, and 10-year Portuguese yields sank 18 bps to 4.99%. The German DAX equities index gained 1.8% (up 5.1% y-t-d). Japanese 10-year "JGB" yields dipped one basis point to 1.05%. The Nikkei 225 gained 1.1% (down 8.6%). Emerging markets were higher. For the week, Brazil's Bovespa equities index increased 0.9% (down 0.7%), and Mexico's Bolsa jumped 1.9% (up 2.5%). Russia’s RTS equities index gained 1.9% (up 4.3%). India’s Sensex equities index rallied 1.5% (up 3.9%). China’s Shanghai Exchange increased 0.8% (down 18.9%). Brazil’s benchmark dollar bond yields dropped 15 bps to 4.11%, and Mexico's benchmark bond yields sank 31 bps to 3.94%.
Freddie Mac 30-year fixed mortgage rates declined 5 bps last week to 4.49% (down 73bps y-o-y). Fifteen-year fixed rates fell another 5 bps to 3.95% (down 68bps y-o-y). One-year ARMs sank 9 bps to 3.55% (down 123bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates unchanged at 5.45% (down 81bps y-o-y).
Federal Reserve Credit declined $3.2bn last week to $2.309 TN. Fed Credit was up $89.2bn y-t-d (6.7% annualized) and $331bn, or 16.7%, from a year ago. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 8/4) increased $8.2bn (7-wk gain of $74.1bn) to a record $3.154 TN. "Custody holdings" have increased $198.6bn y-t-d (11.3% annualized), with a one-year rise of $343.8bn, or 12.2%.
M2 (narrow) "money" supply increased $4.4bn to $8.619 TN (week of 7/26). Narrow "money" has increased $106.6bn y-t-d, or 2.2% annualized. Over the past year, M2 grew 2.0%. For the week, Currency added $1.4bn, and Demand & Checkable Deposits jumped $19.4bn. Savings Deposits declined $7.3bn, and Small Denominated Deposits fell $3.7bn. Retail Money Fund assets declined $5.3bn.
Total Money Market Fund assets (from Invest Co Inst) jumped $19.2bn to $2.819 TN. In the first 31 weeks of the year, money fund assets dropped $475bn, with a one-year decline of $787bn, or 21.8%.
Total Commercial Paper outstanding declined $4.6bn to $1.097 TN. CP has declined $73.4bn, or 10.5% annualized, year-to-date, while it was up $20bn from a year ago.
International reserve assets (excluding gold) - as tallied by Bloomberg’s Alex Tanzi – were up $1.394 TN y-o-y, or 19.7%, to a record $8.483 TN.
Global Credit Market Watch:
August 6 – Bloomberg (Katie Evans): “Expedia… and International Business Machines… sold bonds with coupons at historic lows this week… Debt sales reached $35.9 billion this the week, the most since March 26…”
August 6 – Bloomberg (Tim Catts): “U.S. corporate bond sales in August may reach $100 billion, the most on record for the month, as companies benefit from falling borrowing costs and seek to raise debt before financial firms come to market in September, according to Aladdin Capital LLC.”
August 4 – Bloomberg (John Detrixhe): “Junk bonds are closing in on par for the second time this year as fixed-income investors bet recent signs of economic weakness won’t be enough to derail corporate profits and the ability of the neediest borrowers to repay debt. High-yield bonds rose to 98.99 cents on the dollar yesterday after falling as low as 94.47 cents on May 25… Investors are pouring money into bond funds at the fastest pace in 15 months…”
August 5 – Bloomberg (Bryan Keogh and Kate Haywood): “Relative yields on Europe’s junk bonds are poised to fall below their U.S. counterparts for the first time since June 2008 as concern the sovereign deficit crisis will derail the region’s economic recovery recedes.”
August 4 – Bloomberg (Dawn Kopecki and Jody Shenn): “The Federal Reserve Bank of New York may seek to require banks to buy back its holdings of faulty mortgages and other assets acquired through the rescues of Bear Stearns Cos. and American International Group…, a spokesman said. ‘We are involved in multiple efforts related to exercising our rights as investors in non-agency RMBS or CDO securities,’ New York Fed spokesman Jack Gutt wrote…referring to residential mortgage-backed securities and collateralized debt obligations. Steps include ‘those that require originators to repurchase ineligible loans,’ Gutt wrote… ‘These efforts support our primary goal of maximizing the value of these portfolios on behalf of the American taxpayer.’”
August 6 – New York Times (Graham Bowley and Eric Dash): “They are the elite among the elite at Goldman Sachs, highfliers who are the envy of Wall Street. But on Washington’s orders, Goldman is now considering a step that once would have been unthinkable: disbanding the corps of market wizards at the heart of its lucrative trading operation. Under the new Dodd-Frank financial regulation, Goldman must break up its principal strategies group, the wildly successful trading unit that has helped power the bank’s profits. Goldman is considering several options, including moving the traders to another division or shutting the unit altogether, according to people briefed on the matter. Across Wall Street, other financial giants are also embarking on the delicate task of complying with the new rules governing their trading and investments.”
Global Government Finance Bubble Watch:
August 2 – Bloomberg (Caroline Salas and Jody Shenn): “For all the good the Federal Reserve’s $1.25 trillion of mortgage-bond purchases have done, they’ve also left part of the market broken. By acquiring about a quarter of home-loan bonds with government-backed guarantees to bolster housing prices and the U.S. economy, the Fed helped make some securities so hard to find that Wall Street has been unable to complete an unprecedented amount of trades. Failures to deliver or receive mortgage debt totaled $1.34 trillion in the week ended July 21, compared with a weekly average of $150 billion in the five years through 2009…”
Currency Watch:
August 5 – Bloomberg (Liz Capo McCormick): “Investors reaped bigger gains since the start of June by funding investments in higher-yielding currencies with dollar-denominated loans than similar strategies using Japanese yen- or Swiss franc-based funding… Expectations that the Federal Reserve will keep interest rates at record lows into next year combined with traders’ speculation that policy makers may be forced to resume buying securities to help provide additional stimulus to the economy makes dollar-based funding attractive… ‘The outlook for a return to a dollar-funded carry trade is becoming compelling,’ said Ray Farris, head of foreign-exchange strategy at Credit Suisse…”
The dollar index slumped 1.4% to 80.363 (up 3.2% y-t-d). For the week on the upside, the Norwegian krone increased 2.2%, the Swedish krona 1.8%, the South Korean won 1.8%, the Danish krone 1.8%, the euro 1.8%, the British pound 1.7%, the Australian dollar 1.5%, the Japanese yen 1.2%, the South African rand 1.0%, the New Zealand dollar 1.0%, the Taiwanese dollar 0.7%, the Swiss franc 0.3%, and the Canadian dollar 0.3%. For the week on the downside, the Mexican peso declined 0.3% and the Brazilian real 0.3%.
Commodities Watch:
August 4 – Financial Times (Jack Farchy): “Wheat prices surged more than 7% on Wednesday to a fresh two-year high even as the United Nations attempted to quell growing panic in the markets. CBOT September wheat rose to a fresh peak above $7.30 a bushel, the highest since September 2008, amid rising alarm over the state of the wheat crop in the Black Sea region, which has been ravaged by the worst drought in more than a century. The UN’s Food and Agricultural Organisation said that fears of a repetition of the 2007-08 food crisis were unjustified. But it also cut its forecast for global wheat production by 25m tonnes to 651m tonnes, making the biggest revision in 20 years, and warned that a continuation of the current weather conditions could affect planting of the next Russian crop, with ‘potentially serious implications’ for global wheat supplies in the 2011-12 season.”
August 5 – Bloomberg (Maria Levitov and Maria Kolesnikova): “Russia will impose an export ban on grain and grain products from Aug. 15 to Dec. 31 as the country’s worst drought in half a century cuts yields… Earlier, Putin said a ban would be ‘appropriate’ after drought and record heat in central Russia and along the Volga River forced the government to declare a state of emergency in 28 crop- producing regions… ‘As of today, Russia has no grain market,’ said Kirill Podolsky, chief executive officer of Valars Group, the country’s third-biggest grain trader. ‘This will be a catastrophe for farmers and exporters alike.’”
August 3 – Bloomberg (Maria Kolesnikova): “Russia’s worst drought in at least 50 years, which already drove wheat prices to the biggest jump since 1973, shows no signs of easing and now threatens sowing plans for winter grains, the national weather center said. Plantings scheduled to start in August in the northeastern areas of Russia’s European regions will be hampered by dry soil…”
The CRB index added 0.1% (down 3.1% y-t-d). The Goldman Sachs Commodities Index (GSCI) jumped 1.8% (up 1.8% y-t-d). Spot Gold rallied 2.1% to $1,205 (up 9.8% y-t-d). Silver jumped 2.6% to $18.465 (up 9.6% y-t-d). September Crude rose $1.97 to $80.92 (up 2.0% y-t-d). September Gasoline slipped 0.2% (up 3% y-t-d), and September Natural Gas sank 9.1% (down 20% y-t-d). September Copper added 1.5% (up 0.4% y-t-d). September Wheat surged another 9.7% (up 56% y-t-d), and September Corn gained 3.1% (down 2% y-t-d).
China Watch:
August 5 – Bloomberg: “China’s central bank said inflation risks persist as growth stabilizes in the world’s third-biggest economy. There’s ‘still a need to strengthen the management of inflation expectations,’ the People’s Bank of China said… China’s inflation accelerated to 3.3% in July, the fastest pace in 21 months… Rising labor and resource costs and ‘relatively loose’ global monetary conditions may add to price pressures, the central bank said.”
August 2 – Bloomberg: “China’s July manufacturing data were the weakest in more than a year as the government clamped down on property speculation and investment in polluting and energy- intensive factories. A purchasing managers’ index released today… slid to 49.4 from 50.4 in June. A separate, government-backed PMI fell to 51.2 from 52.1…”
August 5 – Bloomberg (Bryan Keogh and Kate Haywood): “China’s banking regulator told lenders last month to conduct a new round of stress tests to gauge the impact of residential property prices falling as much as 60% in the hardest-hit markets… Banks were instructed to include worst-case scenarios of prices dropping 50% to 60% in cities where they have risen excessively, the person said… Previous stress tests carried out in the past year assumed home-price declines of as much as 30%.”
August 3 – Bloomberg: “China will let more banks import and export gold and open trading further to foreign companies as near-record prices and falling stock markets spur demand in the world’s second-largest buyer of the metal. Gold prices gained. China may ‘increase foreign members on the Shanghai Gold Exchange and will also study ways to allow foreign qualified bullion suppliers to deliver to the exchange,’ the People’s Bank of China said… Banks may also be allowed to hedge onshore gold positions overseas to encourage the development of yuan-denominated derivatives trading, it said. Gold demand in China, the world’s largest producer, gained in the first half as government measures to cool the property market and falling equities spurred investment… ‘China’s domestic production of gold, albeit the largest in the world, cannot satisfy its demand,’ said Ellison Chu, managing director at the precious-metals desk at Standard Bank Asia… ‘By allowing more foreign participation and more Chinese commercial banks to import and export, China can better balance its demand and supply.’”
India Watch:
August 2 – Bloomberg (Kartik Goyal): “India’s manufacturing growth accelerated in July, increasing pressure on the central bank to raise interest rates. Bond yields touched a three-month high. The Purchasing Managers’ Index rose to 57.6 from 57.3 in June… The data, along with rising bank credit and automobile sales, adds to evidence of strengthening consumer demand in Asia’s largest economy after Japan and China.”
Asia Bubble Watch:
August 2 – Bloomberg (Simon Kennedy, Matthew Bristow and Shamim Adam): “The high-speed rail link China Railway Construction Corp. is building in Saudi Arabia doesn’t just connect the holy cities of Mecca and Medina. It shows how Asia, the Middle East, Africa and Latin America are holding the world economy together. Ties between emerging markets form what economists at HSBC Holdings Plc and Royal Bank of Scotland Group Plc call the ‘new Silk Road’ -- a $2.8-trillion version of the Asian-focused network of trade routes along which commerce prospered starting in about the second century.”
August 2 – Bloomberg (Shamim Adam and Novrida Manurung): “Indonesia’s inflation rate climbed to the highest level in 15 months in July… Consumer prices rose 6.22% last month from a year earlier…”
August 5 – Bloomberg (Greg Ahlstrand and Berni Moestafa): “Indonesia’s economy expanded at a faster-than-estimated pace last quarter… Gross domestic product in Southeast Asia’s largest economy grew 6.2% in the three months to June 30…”
August 5 – Bloomberg (Suttinee Yuvejwattana and Daniel Ten Kate): “Thailand’s economy may expand as much as 8% this year, more than previously forecast, as exports and spending gather strength, Finance Minister Korn Chatikavanij said.”
Latin America Watch:
August 5 – Bloomberg (Sebastian Boyd and Randy Woods): “Chile’s economic activity expanded 6.8% in June from a year earlier, beating economists’ forecasts, the central bank said…”
August 5 – Bloomberg (Daniel Cancel and Corina Rodriguez Pons): “Venezuela, the largest oil producer in South America, is shipping 200,000 barrels a day of oil to China to repay $20 billion of debt borrowed from the Asian nation to finance power, agriculture and technology projects.”
Unbalanced Global Economy Watch:
August 4 – Bloomberg (Simone Meier): “Growth in Europe’s services and manufacturing industries accelerated in July… A composite index based on a survey of euro-area purchasing managers in both industries rose to 56.7 from 56 in June…”
U.S. Bubble Economy Watch:
August 6 – Bloomberg (Shobhana Chandra): “The U.S. participation rate fell to 1985 levels in July as job seekers gave up their search in a ‘worrying sign’ the labor market remains weak, according to Ryan Wang of HSBC Securities… The… participation rate, or the share of people who are either working or looking for a job, dropped to 64.6% in July… The labor pool shrank by 181,000 in July, the third consecutive monthly decline. ‘Potential job seekers are not seeing any real improvement,’ Wang…said..”
August 6 – Bloomberg (Simone Baribeau): “The number of workers employed by U.S. state and local governments fell to the lowest since 2007 as municipalities cut payrolls to balance their budgets. Local governments such as cities and counties shed 38,000 jobs in July… Local payrolls shrank to 14.35 million in the second-largest monthly drop since 2003…”
Fiscal Watch:
August 6 – Associated Press (Randolph E. Schmid): “The Postal Service was $3.5 billion in the red for the third quarter and may not be able to make a required payment for future retiree health benefits, the agency said… Losses for the April through June quarter were $1.1 billion more than the post office lost in the same period a year ago… ‘Given current trends, we will not be able to pay all 2011 obligations,’ Joseph R. Corbett, the Postal Service’s chief financial officer, said…”
Central Bank Watch:
August 5 – Bloomberg (Jennifer Ryan): “The Bank of England kept its bond-stimulus plan in place and left its benchmark interest rate at a record low as officials sustained emergency aid for the economy during the biggest budget squeeze since World War II. The nine-member Monetary Policy Committee… held the target for bond holdings at 200 billion pounds ($318 billion)…”
Muni Watch:
August 5 – Bloomberg (Martin Z. Braun and Justin Doom): “New York City’s Transitional Finance Authority increased its offer of top-rated Build America Bonds by 31% to $614 million in its biggest sale of the taxable debt since October.”
Real Estate Watch:
August 2 – Bloomberg (John Gittelsohn): “Gulf of Mexico coastal homes may lose as much as $56,000 each in value as buyers shun areas marred by the worst oil spill in U.S. history, according to CoreLogic Inc. Waterfront properties in Gulfport, Mississippi, face the biggest average declines, followed by those in Mobile, Alabama, and Pensacola, Florida, the real estate data company said…”
2010 vs. 2007:
Greek and periphery European debt markets have stabilized. The euro is above 133, having now recovered back to April levels. Global risk markets have rallied, and commodities markets are again heading north. Throughout the markets, risk premiums have contracted meaningfully. Debt issuance at home and abroad has rebounded. I have posited that the Greek debt crisis provided another critical juncture for global markets. Others contend that Greece is a small country with limited global impact. Moreover, possible effects from Greek problems have diminished as the crisis has subsided. I’m unswayed.
The current environment increasingly reminds me of the long, scorching summer of 2007. The subprime crisis turned serious in early June. And not to pick on Ben Stein, but this week I went back and reread his August 12, 2007 New York Times article, “Chicken Little’s Brethren, on the Trading Floor.” Mr. Stein’s perspective at the time was in tune with the majority of analysts and pundits: subprime was just not that big of a deal; markets had way overreacted.
From his article: “The total mortgage market in the United States is roughly $10.4 trillion. Of that, a little over 13%, or about $1.35 trillion, is subprime… Of this, nearly 14% is delinquent… Of this amount, about 5% is actually in foreclosure… Of this amount… at least about half will be recovered in foreclosure. So now we are down to losses of about $33 billion to $34 billion… But by the metrics of a large economy, it is nothing. The total wealth of the United States is about $70 trillion. The value of the stocks listed in the United States is very roughly $15 trillion to $20 trillion. The bond market is even larger.”
Efforts to quantify potential damage from subprime or, more recently, Greece completely miss a fundamental facet of analyzing Bubble Dynamics: both were examples of the marginal borrower abruptly being denied access to liquidity/Credit in a highly speculative, hence susceptible, (“Ponzi Finance”) financial environment - thus marking critical junctures for their respective Bubbles. The Mortgage/Wall Street Finance Bubble, in the case of subprime, and the Global Government Finance Bubble, with respect to Greece, marked critical inflection points for both market perceptions and stability.
Amid this past month’s global market rally, perceptions have shifted to the view that the European debt crisis is behind us. Recalling the summer of ’07, the subprime crisis “officially” erupted in early June with the halting of redemptions by two structured mortgage product mutual funds managed by Bear Stearns (these funds collapsed later in the month). From a July high of 1,555, subprime worries hit the S&P500 for about 10%, with the market trading below 1,400 intraday on August 16th. Living up to market expectations, the Fed was quick to the rescue.
In an atypical inter-meeting move, the Federal Open Market Committee (FOMC) cut the discount rate 50 bps on August 17th, 2007. With an escalating subprime crisis, speculative markets moved confidently in anticipation of another aggressive round of monetary easing. The S&P500 rallied over 12% in less than two months. After having traded at almost 5.30% in mid-June, 10-year Treasury yields sank below 4.33% by early-September. Despite escalating mortgage tumult, (“safe haven”) benchmark Fannie MBS yields fell from 6.40% in June to 5.40% by late-November. The drop in market yields incited a rush to refi mortgages in late-2007 and into 2008. Dynamics that would culminate in a historic Credit market seizure and liquidity crisis were being masked by melt-up/dislocation in the Treasury and agency markets.
With fed funds at near zero, the FOMC has had little room to cut rates in response to the Greek/European debt crisis and a faltering U.S. recovery. The markets, however, clamored and the Fed delivered assurances that additional quantitative ease would be forthcoming as necessary. Akin to the summer of 2007, markets have rallied in anticipation of a further loosening of monetary conditions. Ten-year Treasury yields closed today at 2.82%, down 113 basis points from the early-April (pre-Greece) high. Benchmark MBS yields are down 111 bps to 3.56%.
The 2007 subprime eruption and the Fed’s response had a profound impact on perceptions throughout various markets. The dollar index – which had traded above 82 on August 16th 2007 – was down to 75 by late-November. The prospect for additional dollar devaluation gave further impetus to buoyant commodities markets. The Goldman Sachs Commodities Index jumped from 485 in August to end 2007 above 600 - on its way to almost 900 by mid-2008. Crude prices almost doubled in 10 months. Many of the “emerging” markets ran to frothy new highs – right before the big fall.
The implosion of the Mortgage/Wall Street Finance Bubble unfolded over about 18 months. There were powerful countervailing forces. On the one hand, a marked change in market perceptions was leading to a reduction in the availability of mortgage Credit. As new buyers/speculators lost their ability to obtain mortgages, it quickly became apparent that many key housing market Bubbles would soon burst. The U.S. housing mania and economic boom were doomed. This led to a broadening panic out of private-label MBS and a liquidity crisis for the overheated ABS/CDO marketplace. The dominoes had started to tumble.
Meanwhile, the behemoth Treasury, Agency and GSE MBS markets (with GSE securities enjoying a combination of explicit and implicit government guarantees) enjoyed big rallies. Liquidity problems in subprime-related sectors were for awhile more than offset by liquidity overabundance in the more dominant fixed-income markets. Ironically, the initial bursting of the mortgage finance Bubble – with all eyes fixated on the Bernanke Fed – fostered destabilizing liquidity excess. The declining dollar; leveraged “dollar carry trades;” an unwind of bearish bond positions and interest-rate hedges; a mortgage refi boom and resulting hedging against MBS pre-payment risk; Fed-induced speculation on lower market yields; a bout of safe-haven buying; and large foreign central bank Treasury purchases all combined to create an over-liquefied and highly-speculative market backdrop. The resulting liquidity-induced rally throughout global risk and commodities markets only exacerbated systemic vulnerabilities to the unfolding Credit and economic crises.
I highlight the 2007/08 experience as a reminder of how bursting Bubbles and financial crises can (tend to) evolve over many months – with surprising ebbs and flows and occasional confounding twists and turns. I don’t see anything in the current backdrop that tempts me to back away from my view that the Greek crisis marked a critical change in market perceptions. Those that dismissed how the subprime eruption had fundamentally altered the financial landscape would later regret their complacency.
Today, I believe global faith in government policymaking has been badly shaken. There is now an appreciation that policymakers are running out of options. Confidence that fiscal and monetary stimulus ensures a sustainable global recovery has waned. There is recognition that massive stimulus can’t assure market stability; in fact, profligate fiscal and monetary measures will likely prove destabilizing. There is appreciation that global central bankers can’t guarantee normally-functioning markets. There is, these days, no denying that structural debt issues will be a serious ongoing problem. And, importantly, the world is increasingly keen to the severity of U.S. financial and economic problems. Indeed, the post-Greece backdrop beckons for reduced risk and less leverage. Yet the markets can – at least for a period of time – luxuriate in destabilizing policymaking-induced liquidity excess and dysfunctional markets.
The dollar is in trouble. Our currency has now dropped for nine straight weeks, sinking to a near 15-year low against the yen. Crude oil traded above $82 this week. Wheat prices are up about 50% over the past month. The last thing our struggling economy needs right now (in common with 2007/08) is surging energy and food prices.
And there is clearly interplay at work between tumult in the currencies and dislocation in our fixed income markets. Fed talk of QE2; rumors of the Administration forcing Fannie Mae/Freddie Mac to refinance and/or reduce principal on troubled mortgages; the potential for a wave of mortgage refinancings; and the likelihood that many have been caught on the wrong side of a major move in market yields have Treasury, agency and MBS yields in near freefall.
August 2 – Bloomberg (Caroline Salas and Jody Shenn): “For all the good the Federal Reserve’s $1.25 trillion of mortgage-bond purchases have done, they’ve also left part of the market broken. By acquiring about a quarter of home-loan bonds with government-backed guarantees to bolster housing prices and the U.S. economy, the Fed helped make some securities so hard to find that Wall Street has been unable to complete an unprecedented amount of trades. Failures to deliver or receive mortgage debt totaled $1.34 trillion in the week ended July 21, compared with a weekly average of $150 billion in the five years through 2009… The difficulty of executing transactions may eventually drive investors away from the $5.2 trillion mortgage-bond market, which has historically been the most liquid behind U.S. Treasuries, potentially causing yields to rise, according to Thomas Wipf… The unsettled trades also stand to exacerbate the damage caused by the collapse of a bank or fund. ‘You’re adding systemic risk into the market,’ said Wipf, chairman of the Treasury Market Practices Group and the… head of institutional-securities group financing at Morgan Stanley. ‘Investors are taking on counterparty risk in trades they didn’t intend to take on.’ An incomplete agreement can lead to a ‘daisy chain’ of unsettled trades because a broker-dealer acting as a buyer in one transaction may fail to deliver those bonds as a seller in another, according to Alexander Yavorsky, a senior analyst at Moody’s… Investment banks are required to hold capital against both sides of the trades, which also makes the agency mortgage-backed market less attractive to make markets in…”
It is worth noting that Treasurys held in reserve by foreign central banks at the New York Federal Reserve Bank have surged $74bn in just seven weeks. Dollar weakness appears, once again, to be forcing foreign central banks back into the role as “backstop bid” for the dollar in global currency markets. These dollar balances are then “recycled” back into our Treasury market, a dynamic that does not go unrecognized by the speculator community. This presses market yields only lower, increasing the risk of prepayment on mortgage securities and forcing additional interest rate hedging (further exacerbating the decline in market yields). And once a market dislocates, many will pile on in search of easy speculative profits.
With Treasury, Agency and MBS prices melting up (yields in melt down), key markets enjoy extraordinary, albeit destabilizing, liquidity abundance. Understandably, market participants dismiss talk of U.S. structural debt issues. Many will justify the move on fundamental grounds – “It’s deflation, stupid!” Ironically, collapsing yields, the sinking dollar, surging commodities, recovering global risk markets and the onslaught of global liquidity create a backdrop conducive to future inflation surprises.
Reminiscent of 2007/08, the initial crisis phase has unleashed wild volatility and instability throughout various markets. Some can see that the glass is less than half empty, while attentive central bankers and sinking yields have most viewing things as positively full. The havoc and misperceptions create an increasingly dysfunctional market landscape. Over time, the volatility, uncertainty and escalating market stress will prove a subprime-like wrecking ball on confidence. I need to go back and count the number of trading sessions in 2008 between seemingly over-liquefied markets and Credit market seizure.
My expectation remains that markets, having disciplined Athens and initiated austerity in the euro-zone, will inevitably set its sights on Washington profligacy. Too reminiscent of the Mortgage/Wall Street Finance Bubble, the markets seem determined to ensure that this disciplining process is methodically delayed until the very maximum levels of Credit excess, speculative froth, market distortion, and systemic vulnerability have been achieved.