Some interesting charts & tables from the latest Global Financial Stability Report by the IMF.
Some interesting charts & tables from the latest Global Financial Stability Report by the IMF.
The 10 year Treasuries have set a picture perfect bounce off the 200 day moving average (DMA) which is the ceiling resistance and today’s sharp drop in yields favors a trend move down towards the 50 DMA at 1.589.
The gap-down in yield that occurred today – the empty space between the price – also lends some credence that yields are probably heading lower – and none of this is good for the stocks.
We would have to see what happens to the yields at the 50 DMA because two things can happen there: either yields bounce higher (bullish for stocks) or break down lower which is bearish for stocks.
Highlighted are also regions where the yields are bouncing off the top and on previous occasions such bounce was associated with the major tops in the S&P (bottom chart panel). Only during a meaningful break out of the yield’s ceiling like November 2010 did we see S&P grind higher.
The obvious inference of this is that things are likely to repeat and if they do today’s gap lower in the Treasury yield maybe also associated with a market top… just another unfortunate coincidence.
This year’s top 2 asset performers so far have been debt paper with the Emerging Market (EM) debt leading the gains (12.8%) with high yield global bonds just behind in gains.
Hungry for yield and relative safety, the fixed income people have been scooping paper of countries that several years ago one would hardly consider to be paragons of safety let alone their sketchy credit history. Yet debt paper of likes of Poland, Mexico, Peru and Russia are hot: Polish paper is flirting with negative yields while, may we recall, Mexico and Russia have had their bouts with defaults.
For example, JPMorgan’s USD Emerging Markets Bond Fund (EMB) is heavy on Philippines and Peru paper and the overall rating concentration is inside the BBB and B- range yet the chart of EMB is of envy.
So is the chart of another dollar denominated debt ETF – the PowerShares EM sovereign debt portfolio (PCY).
These two ETFs are not interested in holding paper issued in local currency so should these countries get into trouble like experience sudden capital outflow or get high inflation the debt itself will become questionable.
Now, rally in these ETFs is in its third year, so the question is whether we are close to the top and if so is it worth investing our marginal dollar into these instruments.
Some people, of course, may feel queasy at holding debt paper of unknown governments when they harbor mistrust in their very own, but based on what some economists are saying the rally in these ETFs is not just demand driven but lack of supply and prospects for continuation of such scarcity may drive these shares still higher.
In April 2012, IMF has concluded that the “safe asset demand is expanding at the same time that the universe of what is considered safe is shrinking.”
Of course, the key problem here is what is the definition of “safe” and whether going down the credit ratings food chain is the way to satisfy the safety criteria.
Still, between all of the QEs and cash sloshing the bank reserves, to fixed income demand from insurers and pension funds, “it is clear” the IMF says “that the demand for safe assets is subject to considerable upward pressure.”
Is there enough supply?
Well, as the graph below notes, the AAA-rated paper among the advanced economies has shrunk from 68% to 52% – a $15 trillion contraction in supply – while the lower AA-rated debt in emerging markets went up by 5% obviously an insufficient offset.
Using CDS spreads, IMF projects that by 2016 safe paper could drop additional $9 trillion while private sector “safe” debt is seen, at best, flat.
What happens in the emerging markets?
“In emerging markets, prudent fiscal policies together with ongoing improvement in domestic financial infrastructure—including legal certainty, clearing and settlement systems, and transparent and regular issuance procedures—will support further deepening of local sovereign bond markets. Over the longer run, these improvements will facilitate the use of such securities as safe assets both within their domestic context and possibly in global markets,” say the IMF.
In other words, IMF sees a generally rosy fiscal and regulatory picture for the EMs which, of course, is bullish for their existing dollar-denominated debt paper.
Yet all these countries are loath to issue any new debt a prospect that signals no new significant debt issue by these. In fact, as of 2009, EMs accounted for 40% of the global GDP while their debt accounted for 20% of the advanced markets.
Then again, all of these issues that IMF wrote in April are likely to have been discounted into the price of EMB and PCY and as a result we have an overextended chart above all major moving averages as well as a persistently overbought relative strength measure.
Supposing a resolution to the Eurozone problems, lots of cash will be set to exit these ETFs. Absolute Return Partners Niels Jensen alludes to this powerful set up.
“If structured correctly, a Eurozone exit is not the Armageddon it is so often portrayed to be. When the perma bears realise that, and as they begin to see the benefits bestowed upon the first mover, the mother of all equity bull markets will be unleashed in Europe. As I have frequently pointed out in recent months (see for example here), European equities are extraordinarily attractively priced at levels not experienced since the dark days of the early 1980s. We are just waiting for the catalyst, but remember one thing – banks will not be the place to be,” notes Jensen in his June outlook.
Negative events in the European bond market have a contagious effect on the US corporate debt paper but that influence is less than one-for-one and it depends on the paper quality as well as the sector finds the latest San Francisco Fed study.
“Interest rates on U.S. corporate bonds have been affected by corporate bond market shocks originating in Europe over the past three years. In particular, we estimate contagion coefficients of around 0.44 to 0.85, meaning that a 1 percentage point increase in European corporate bond spreads translated on average to a 0.44 to 0.85 percentage point increase in corporate bond spreads in the United States,” note authors Galina Hale, Elliot Marks, and Fernanda Nechio.
According to the analysis, a 1% increase in EU corporate spreads based on news corresponds to 0.67% effect on the US corporates.
A 1% change in spreads based on EU ratings has a 0.44% to 0.85% effects on the US spreads.
Disaggregating the debt paper by sector as well as by the rating shows that US spreads in the financial sector are affected more then 1-to-1 on AAA paper while the effects on the nonfinancial sector for such paper is very small.
Full text here.
Since the 1990s, US has been migrating from one price bubble to the next: internet stocks and houses all rose at a record clip only to fall spectacularly.
Since 2008, bond prices have been rising at a record clip, ergo many think that there is a bond “bubble” that, because of the run up, it will eventually burst.
Lately, bond-bursters have been generating support from Warren Buffett who said that bonds “should come with a warning label”.
Buffett’s comments are a far from the ominous “weapons of mass destruction” he used to describe mortgage securities before they imploded and this weekend, Buffett explained what he means by the warning label.
“Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse fosters movement to sterile assets such as gold,” wrote Buffett in his highly anticipated letter to his shareholders.
While gold, notes Buffett, depends on an ever widening pool of new buyers, we hear no such comments from him about bonds.
“What motivates most gold purchasers is their belief that the ranks of the fearful will grow… Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses… In these bubbles…” runs Buffett’s rhetoric.
If bonds are not in the bubble, then what’s up with them?
Buffett does not like bonds, not because they are in some sort of a bubble, but because it belongs to a group of instruments that “have destroyed the purchasing power of investors in many countries”.
“Current rates, however, do not come close to offsetting the purchasing-power risk that investors assume. Right now bonds should come with a warning label,” says Buffett.
Due to liquidity needs and not the yield, Buffett holds no less then $10 billion in very short term Treasuries.
… and this brings us to the crux of what differentiates the recent price appreciation of bonds against other asset bubbles like internet, houses and gold: bond buying is not driven by leveraging but by parking one’s cash after a bout with a delever.
In other words, appreciation in bond prices is not associated with leveraging and instead, it is often associated with the opposite, as a cash preserve.
While bubbles in internet and housing burst because of deterioration in solvency of investors in those assets, the bond “bubble” bursts due to the solvency deterioration, not of the investor, but of the bond issuer.
Another feature that makes our bond “bubble” different from others is that central banks and its printing presses can prolong that bubble indefinitely and in all likelihood will work hard not to precipitate a sudden rise in yields.
In fact, central banks are all to eager to control yields across the curve: from QE attack on short term, to reinvesting the income stream on various maturities to operation twist attacking long term yields.
Because of these two distinctions, it is unlikely that a spectacular bond crash would occur although as Buffett warns a spectacular bout with inflation is an ongoing scenario.
There is, of course, an argument to be made that, as central banks have been stepping up on their printing presses since the early 1990s, they have finally reached the end of what they can manipulate – the bonds.
Eventually, something will have to be done on the fiscal side.
Now that the credit rating has been downgraded for most of the Eurozone countries the 4 remaining with the AAA rating may not offer sufficient amount of debt to maintain good enough liquidity of such high rated paper.
Germany, Finland, the Netherlands and Luxembourg remain the only AAA Eurozone sovereigns with total debt offering among them at 949 billion Euros. Of that amount, Luxembourg claims a negligible 4 billion.
Will we see a run up on these debt issues? Perhaps but funds may also change their investment guidelines now that there is an insufficient amount of AAA rated debt.
With most Eurozone sovereigns experiencing funding relief post-downgrade, Portugal’s dependence on the EFSF and a perception that it is next in line after Greek (dis)orderly default may be contributing to its higher funding costs.
Is the lack of Eurozone AAA debt paper the cause of the ever widening trend between the equities and the 10-year yield?
Probably because many funds and central banks are on an automatic pilot and would buy only a certain amount of top rated debt … but to what extent is Eurozone’s lack of worthy paper driving the equities-yield wedge is unclear now.
These two things tend to correct themselves at some point hence nervousness some traders are expressing at the current equities rally.
With a striking distance of a 100% retracement of May 2011 highs some clarity on this issue may be gotten in the second half of this month.
Foreigners bought $60.1 billion of US Treasuries in August marking a sharp reversal from July when foreigners took out $52.4 billion.
Net foreign purchases of Treasuries, housing agency and corporate debt increased $57.9 billion in August.
China cut its Treasuries holdings by $36.5 billion and it now has $1.137 trillion.
New York Fed has published a study today in which it examines cross-country influence of bond yields and concludes that unexpected rise in US bond yields causes larger changes to bond yields among major industrialized countries then the other way around.
In International Spillovers on Government Bond Yields: Are We All in the Same Boat? analysts Vivian Z. Yue and Leslie Shen show that a 1% increase in US bond yields causes 0.35% rise in Germany, 0.25% rise in Japan and 0.42% rise in UK.
By contrast, a 1% yield spike in each one of these countries cause US bond yields to go up by 0.23% if from Germany, 0.05% if from Japan and 0.18% if from UK.
On average, an unexpected 1% rise in US bond yields has an immediate impact of 0.14-0.19% on yields in industrialized countries.
As seen by these calculation, US-Japan linkage is the weakest and this weak correlation is seen in the correlation graph below as a green line that does not go pass 0.4 while other ones tend to have a higher coefficient.
In general, US shocks explain 5.8% of daily variance in German bonds, 3.6% for Japan and 5.7% for the UK. On a five day forecast, the variance increases: Germany – 6.4%, Japan – 9.2%, UK – 6.4%.
What about the relationship with other developed countries besides these three?
The authors say that 30% of the “shock to the U.S. bond market” directly impacts bond markets elsewhere.
Full text is available here.