August 2003

Runaway Trains

Flashing Red Warnings Unseen In The Rain, This Thing Has Turned Into A Runaway Train...Let's face it, it's simply not often that we experience a sell off in the Treasury market as we have over the past six weeks.  This is clearly as significant a negative move as anything we can remember in recent history.  As we'll address in a moment, during the three days surrounding the recent Greenspan testimony (formerly known as Humphrey-Hawkins testimony), the Treasury market experienced a three day rout that ranks among the top five three day "corrections" in bond market history.
     

But what has really been more surprising to us than not is that the significant events taking place in the globally important and sizable US fixed income markets are not creating flashing red neon screaming headlines.  No covers of Business Week, Fortune or Time.  Instead, such fountains of knowledge as financial Comedy Central (CNBC, etc.) have alternatively been intensely focused on the recent corporate earnings release period.  After all, what could be more important to our lives than companies potentially "beating the earnings estimates", right?  Three years into one of the worst equity bear markets of a generation, we are certainly well aware of how meaningful beating analyst estimates are to our collective financial future.  For ourselves, the events that have transpired in the Treasury market over the past three to four months simply epitomize and reflect the incredible imbalances we face in the current global financial and economic environment of the moment.  Action in the Treasury market is telling us that these imbalances may be approaching a period in which extremely heightened price volatility is suggesting that the beginnings of imbalance reversion on many fronts may be upon us right now.

In this discussion, we'd like to paint you a picture of our version of recent bond market events and suggest financial and economic outcomes that may lie ahead.  Given our belief that we have been living in one of the greatest credit cycles of a generation over the past few decades, it's almost inconceivable to us that what is happening in the fixed income world isn't being given absolutely front and center attention by the Street.  It may very well be that the greatest secular bond bull market of our lifetimes is reaching a conclusion at the exact time where the US economy and financial markets find themselves more levered than at any time in modern history.  

We're Lighting The Fuses And Counting To Three...You'll remember that in last month's discussion we chronicled just how important foreign capital has been in supporting US financial asset prices over the last two to three years.  Especially on the fixed income front.  At the time, because the information had not yet been made publicly available, we had no idea that the foreign community had just purchased $100 billion of US fixed income assets in May - a record.  Purchases of agency paper were a one month record.  The level of foreign purchases of Treasury securities alone in May had not been experienced since May of 1996.  One month corporate debt purchases rose to a two year high.  And this was all happening while interest rates were approaching three to four decade lows.  The following chart details foreign purchases of US fixed income assets over the past few years.  As a yield reference we've overlaid the like period 10 year Treasury.
           

We believe the above picture is an illustration of the consequence of significant imbalance.  In this case, the imbalance driving what you see in the chart is global dependence on the US consumer.  A dependence that has led to extremes in financial decision making on the part of the foreign community.  As you can see above, in early 2002, foreign buying of US fixed income assets appears logically investment driven.  Monthly purchases by foreigners accelerated as yields increased and subsided as yields fell.  But something changed in latter 2002 into early 2003.  And that something is that foreign purchases of US fixed income assets were more becoming driven by the desire to influence currency exchange rate differentials than not.  Foreign entities, especially the folks in Japan, were openly purchasing Treasury securities in hopes of trying to support the dollar versus their own currencies.  During May, Japan alone purchased $39.4 billion of Treasuries.  It seems pretty clear that trade driven reinvestments by the foreign community in US financial assets were targeting exchange rate manipulation as opposed to being primarily investment related.  Why else would a record one month purchase of US fixed income assets occur when the ten year Treasury yield was the lowest in decades?

We believe the following relationship may be critical in terms of partially understanding why Treasury yields in May through mid-June dropped very significantly.
         

As is clear, the dollar was weakening throughout April and began to accelerate downward in May - the exact month that the foreign community really poured it on in terms of Treasury purchases (led front and center by the Japanese).  Although for now it's conjecture on our part, because the data is not yet available, was there really a need for continued strong Treasury buying by foreigners in June as the dollar had certainly begun to stabilize?  IF the foreign buying of US fixed income assets is really an attempt to move relative currency valuations, then when the dollar is rebounding against foreign currencies it would follow that there isn't quite as big a need to buy on the part of the foreign community.  Could this be in part exacerbating the current sell off?  A lack of foreign buying?  We'll know when we get the foreign capital flow data in a few weeks, but it's pretty clear that the correlation between relative movements in the dollar and ten year Treasury yields are far too coincidental to ignore.

Very quickly, a bigger picture view of the dollar and the ten year Treasury yield relationship tends to reinforce what may be the message in the shorter term chart above.  It certainly seems more than just a fluke that near the exact dollar peak, USD movement relative to 10 year yields became quite coincident as opposed to what characterized the 2+ year period leading up to that peak.
           

From our perspective, what may very well have been the anomalistic top in Treasury prices during May and early June, appears to have been largely driven by the perceived need on the part of the foreign community to support the dollar vis-à-vis the purchase of US fixed income assets.  But as the dollar started to stabilize and strengthen in late May and early June, the need to continue with purchasing US fixed income assets at a record breaking pace may have subsided substantially.  Those that may have been left purchasing at that time were the final momentum players and mortgage backed holders needing to preserve portfolio duration buy buying long maturity securities.  Again, we'll have the real data in just a few weeks, but by reducing buying demand in June and July, the foreign community may have lit one of the sticks of financial dynamite lying along the bond market train tracks.  Tracks from which the bond market has subsequently experienced a significant derailment.  All borne of the need on the part of the foreign community at the time to attempt to perpetuate the US trade imbalance through currency influence.

The Curves Around Midnight Aren't Easy To See...Following directly on the heels of what appears to have been a largely foreign sponsored US fixed income buying panic in May, the man that the domestic leveraged speculating community had come to revere as their savior in this country delivered them a sucker punch in his recent state of the economy soliloquy.  A sucker punch that literally threw gasoline on what was then an already smoldering bond market bonfire.  As you know, since the infamous Bernanke "printing press" speech last year, the Fed has been warning about "an unwelcome drop in inflation" as being unacceptable.  Speaking of its ready armaments to battle deflation, the Fed led the market down the path of expecting potential unconventional measures ultimately being enacted to slay the price compression dragon if need be.  Whether intentional or not, the deflation horror show put on by the Fed over the last nine months or so did indeed spark lower long term interest rates.  Exactly the prescription most would have assumed likely for a Fed wanting to motivate borrowing and spending.  

But in the economic testimony it became relatively clear that the Fed was shifting posture regarding deflation.  Greenspan suggested that the need to invoke unconventional monetary warfare was now "remote".  Not exactly music to the ears of a levered, and otherwise, fixed income investment community.  As you know, over the last two to three weeks, there has been a lot of complaining from certain segments of the fixed income world along the lines of how they have been betrayed by the very same Fed who so diligently catered to this crowd over the past decade-plus.  A Fed who never batted an eye about rescuing leveraged bond market speculating gone bad in the past, and, in fact, implicitly acted to encourage such levered speculation.  From the point of view of many a levered fixed income participant, the Fed pulled out the spikes holding down the tracks ahead of the onrushing bond bull market freight train with its 180 degree philosophical hairpin turn.  

One last comment on the Fed.  Maybe the seeming about face isn't so hard to understand.  If the Fed, and various other pundits, continually batter us over the head with Cassandra-like pontifications about potential deflation, aren't they implicitly getting the message across to consumers and potential corporate spenders alike to defer purchases?  Why spend now when the Fed is worried about prices actually falling?  At least as per the bond market action of the past few months, the Fed had been pretty darn persuasive in terms of deflation chatter.  Did they feel at the time of Greenspan's testimony that they had been too persuasive given the lack of significant bounce in the economy post the initial Iraqi operation?  Just maybe a light bulb went off over the collective heads of the Fed and somebody realized they had been sending a negative message of reinforcement regarding deflationary expectations, as opposed to trying to reinforce inflationary expectations.  

Has the Fed now adopted the policy of trying to aggressively manage expectations of a better economy to come?  IF the Fed can get consumers and corporations to believe that they are more than willing to tolerate inflation and that it is exactly inflation that lies ahead as opposed to deflation, wouldn't that implicitly send the message of "you better spend now before prices are higher"?  Much more constructive than sounding the deflationary alarm bells if one wants to motivate capital spending and continued consumer spending.  Convince and ye shall be convinced?  We have to believe the Fed is becoming fatigued.  Fatigued battling for the sustainability of imbalances.  Potentially falling, at least for a time, on the latest sword chosen to fight the ongoing battle against bubble fallout.

Regardless of the Fed's intentions, Greenspan offered zero conciliatory remarks for bond investors during his most recent testimony.  And that's all it took for the levered speculating community to leap to the conclusion that it had been abandoned by its mentor.  As we said at the outset, the Monday through Wednesday Treasury market action surrounding the days of Greenspan's recent testimony was one of the top five worst consecutive three day bond market sell off's in history.  The bond market fire was now fully ablaze.

Blind Boys And Gamblers, They Invented The Blues.  We'll Pay Up In Blood When This Marker Comes Due...We have heard that over the past 18 months, roughly one half of US mortgages have been refinanced.  Unfortunately we cannot corroborate this data, but it may not be too far off the mark, if at all.  With the recent backup in largely Treasury indexed mortgage rates, it's a good bet that the best days of refi madness may be behind us.  (Please note that we've used the 6.5% level as the current 30 year conventional mortgage rate.  As you know, rates vary with both lenders and geographically across the country.  Freddie Mac's average numbers are in the low 6% area as of the week ended 8/1.)
         

Much more importantly, holders of the mortgage paper generated over the past 18 months (as well as mortgage investors in general) are feeling an incredible amount of price pain as the net present value of the paper they hold is falling in value with every basis point uptick in both mortgage and Treasury rates.  As interest rates increase, the duration, or simplistically the average maturity, of mortgage portfolios extend, hence the decline in the present value of total future cash flows.  In what is close to a $5 trillion mortgage market, there are few ways to ease the pain.  Actions such as shorting longer dated Treasuries, like the 10 year Treasury, are a popular hedging technique to allow mortgage paper holders to negate duration or maturity extension risk to the greatest possible extent.  Of course the academic chain of events is such that shorting or outright selling begets lower prices (higher yields), which in turn begets more selling to negate a now heightened portfolio duration, etc.  Over the past few weeks, the mortgage, Treasury, swaps, government agency, and corporate bond markets have collectively experienced one of their worst one to two week periods since possibly the LTCM blow-up days.

What makes matters worse in the current period is the absolute dollar math.  Because interest rates are at such low levels, yield backup's of approximately 140 basis points on the 10 year can inflict much more investment dollar value damage than when the general level of rates is higher.  At four plus decade low interest rate levels in mid-June, the recent sell off has been nothing short of seismic for the mortgage paper and broader fixed income community.  

And, as you know, if there has been any anomaly in credit creation over the past few years, it can be found in the mortgage area.  Since year end 1999 alone, the following table details sector specific credit expansion:

At least for now, it's an imbalance that's come home to haunt us.

Lastly, recent fixed income market activity is having a pronounced negative influence on the interest rate swaps area.  As you may remember from some of our discussions, it's the single largest area of derivatives activities for the US banking system.  As we have also discussed many a time, the US corporate sector has made copious use of interest rate swaps over the past decade in essentially swapping their longer term fixed payment obligations for short term floating rate liabilities.  It has worked like a charm during what has been a long cyclical period of declining short term interest rates.  Once short rates no longer cooperate, these swap aficionados have a problem.  As you know, the recent bond market downturn has swept yield higher across the curve, not just at the long maturity end.  Once again, we find leveraged bets that have worked consistently during the course of the mega bond bull market rearing their dark sides in periods of extreme volatility such as we have been experiencing.

And What Are The Choices For Those Who Remain, The Sign Of The Cross Or The Runaway Train?...Does a derivatives debacle lie ahead?  Will Treasury rates be driven significantly higher as a result of the ongoing negative vortex of mortgage portfolio hedging?  Is this the 100 year flood?  The end of the world as we know it?  It's easy to whip one's self into an emotional frenzy.  There certainly is at least some probability of occurrence for any or all of the above.  But from our perspective, we view the current experience and certainly increased volatility in the fixed income markets as importantly highlighting imbalances, and possibly marking the point where market participants have a greater respect for both those imbalances and the potential for forward financial market volatility in terms of the returns they ultimately demand for risking their capital in these markets.  

Viewing the recent action from afar, will the foreign community be so willing as to continue supporting the US fixed income markets in their purchasing leadership role as they truly have over the past two to three years?  Will they recognize that attempting to support the US trade imbalance via the mechanism of purchasing US fixed income assets (supporting the dollar) can at times have quite negative consequences for their US dollar denominated financial asset holdings as US interest rates possibly enter a new period of heightened volatility?  

On the home front, will mortgage backed players be so willing as to commit future capital to the markets at any rate of return spread relative to Treasuries simply just to stay in the game?  Will they begin to factor the recent volatility into pricing ahead?  Will they realize that duration risk in their portfolios is more significant at these low levels of interest rates than at possibly any other time over the last few decades at least?  And what about the forward use of leverage in mortgage investment activities?  What about the derivatives players?  Just how will pricing in these markets be influenced going forward while the volatility of the present remains fresh in the minds of the market participants for many moons to come?  At least for now, it's pretty clear that neither the Fed nor the GSE's are the saviors of the moment.  Have fixed income market participants lost their moral hazard benefactors?  If so, it's a good bet the leveraged speculating game will slow down in a big way.  And that has direct implications for the real economy.

And what will become of the forces that have driven the macro credit cycle of the last few decades as these forces meet up with the Fed's clear and present intentions to reflate the economy?  At least for now, the back up in interest rates has stopped the refi momentum dead in its tracks.
       

More importantly, it's our feeling that any type of slowdown in macro credit creation will ultimately throw up a huge roadblock to Fed efforts to reflate.  And that roadblock is money supply expansion.  Remember that the academic definition of deflation is money supply contraction, the flipside being inflation that is money supply expansion.  We'd guess that probably the last thing the Fed would like to see now is a slowdown in the growth of the monetary aggregates (M1, M2, M3, MZM).  For now we're a good ways away from that, but the potential for a significant slowing in money growth or even a trip into the land of real contraction would be transmitted through activity, or lack thereof, in the mortgage credit markets, consumer credit and corporate debt markets.  It is clear to us in the following chart that money growth and interest rate movements are highly correlated.  (Please note that the monthly data is only through June month end.)
     

If current interest rate levels continue to hold, will the recent back up in yields result in a meaningful decline in the rate of money supply growth ahead?  It all depends on credit creation.  Now we're back to housing and sympathetic refi activity.  Now we're back to autos loans.  Now we're back to consumer lending.  Now we're back to corporate debt expansion.  The asset leveraging game needs to continue for money supply growth to forge ahead in anything other than mediocre fashion.  Unfortunately the Fed is powerless to force folks to borrow.  Moreover, as interest rates rise rapidly over a short period of time, the real rate of interest (relative to inflation) is increasing significantly.  We simply can't remember the last time we saw an economic recovery borne amidst a meaningfully rising real interest rate environment.  The end of a bubble period in bonds that translates into a marked slowdown in mortgage, consumer and corporate credit creation would certainly pop the Fed inspired dreams of an easy economy wide reflation ahead.  

For Those Who Wave Lanterns At Runaway Trains...There is simply no question in our minds that the severe collapse in bond prices over the past month and one half is a reflection of the multiplicity of straining global financial and economic imbalances that exist at the moment.  Imbalances that not only reinforced bond prices on the upside, but are now negatively influencing and reinforcing downside price action.  Without debate, current bond market action is nothing if not a reflection of the highly levered nature of our financial markets.  Financial markets that learned to increasingly be accepting of leverage in what was a one way street fixed income market of the past two decades.  A street that may have just encountered a dead end.  At least for a time.  The bond market action of the last six weeks tells us that global and financial imbalances are knocking on the door of reconciliation.  These imbalances are screaming at us that they cannot coexist indefinitely.  At least not peacefully, anyway.  We have the feeling that if no one is listening, they'll just knock louder as we move ahead.

We expect the behavior of financial market participants ahead to change given our most recent experience.  Too much money has been lost over the past six weeks for this episode of volatility to be forgiven in pricing anytime soon.  And that tells us one thing and one thing only - the price of credit is going up.  Because what's different this time is that the Fed no longer has any magic bullets.  In fact gunning for Greenspan and friends on the streets of Dodge will be the return of the bond vigilantes.  Vigilantes who stopped using bullets long ago in deference to something much more deadly to the domestic and global economies and financial markets - basis points. 

Do current events possibly mark the beginning of the end of the greatest credit expansion cycle in US history?  You'll just have to ask your lender.  After you've revived him or her from their recent bond market driven shock induced coma, of course.