Bond bubble today and tomorrow ... Bond crash the day after tomorrow

Long-term rates that can not rise on short term, despite the abysmal public deficits ...

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If we stick to the basics of traditional macroeconomics, the magnitude of the deficits would have led to higher long-term interest rates on public debts including those of areas still supposedly safer: U.S., UK and Eurozone core (mainly France and Germany). The classic phenomenon of strong competition between private and public issuers to raise money in bond markets generally creates a supply-demand imbalance resulting in a rise in long-term yields (government bonds and corporate debt combined). This phenomenon is known by economists as crowding out.

But traditional macroeconomics taught here and there is shattered and we continue to live in an environment of low long-term rates despite the heavy deficits (We will refer to long-term rates while talking about borrowings of US, UK and Eurozone core). This is not a big surprise for us taking into account the following (more than a year ago we already mentioned the risk of falling long-term rates on government bonds, and, worse, retention to sustained low level)

Five reasons prevent long-term rates from rising and could even lead to a decline.

1 / Western deficits continue to be funded (we say "monetized" in Europe) by domestic central banks of emerging countries and oil exporters; the former issuing their own currency to sell it against US dollar for their economies to remain competitive ( Asian growth model based too much on exports), while the latter are to recycle their structural surpluses of foreign exchange reserves (which simply reflect their trade surpluses)

2 / Some Western central banks now practice quantitative easing, currently on spotlight. We think especially to the Fed which had hinted at the FOMC of 10/08/2010 and 21/09/2010 intentions to monetize government deficits through purchases of Treasuries, and has confirmed his intentions at the FOMC of 03/11 / 2010; the goal is naturally to print money to lower long-term rates (short-term rates can no longer drop), create inflationary expectations to break the deflationary psychology (which has undermined the Japanese economy since exactly 20 years) and implicitly devaluate its currency in defiance of international monetary cooperation; a behavior that is not new because we have actually been aware of it since John Connally, U.S. Treasury Secretary in 1971, and his formula "The dollar is our currency and your problem".

3 / Monetary policies of major central banks will remain sustainably expansionist and this naturally leads investors around the world to accumulate transformation positions which are profitable today: I refinance, on short-terms rates virtually free conditions, purchases of government securities of U.S, UK, French and German (4% yesterday, between 2% and 3% today, perhaps between 1.50% and 2.00% tomorrow since margin would still be positive and will remain positive given a context of irreversibility of monetary policy).
Irreversibility because one can wonder if central banks FED, BOE, ECB may one day put an end to their accommodative monetary policy. We believe that the issuing institutions are facing a new paradigm and they are probably doomed to not being able to raise their key rates.

Having used banks to refinance government securities on favorable monetary terms, they can not afford raising their rates, which would complicate public debt refinancing by the banking sector; especially as restrictive monetary policies would cause a sharp steepening of the yield curve, a rise of government bonds rates and thus a sharp depreciation of financial institutions bond portfolios (even if those unrealized losses will not directly affect income statement of banks under IFRS, this would weaken their real solvency and rekindle fears of a systemic crisis) ... Like the Japanese central bank who could never raise its rate from 1996-1997, our Western central banks are forced to follow the same path.

4 / Changes in investor behavior
Risk aversion is durable and changes investors perception of so-called risky assets; this phenomenon feeds a structural situation of flying to supposedly - wrongly or rightly - quality or non-risky asset (now the U.S. government bonds, UK and Eurozone core).

5 / developments related to prudential regulations
Basel 3 for banks and Solvency 2 for insurance, will make capital scarcer and more expensive for companies. Beyond necessary recapitalisations to strengthen balance sheet liabilities, care must be taken at the balance sheet to save equity by focussing on investments with low capital consumption ( government securities of best rated countries )

Long-term rates will not rise on short term also because of pure macroeconomics reasons

And then there are still some laws of traditional macroeconomics that reinforce our views.

All economics students have learned that excess savings over investment leads mechanically to a sustainable pressure to cut rate (a little wink to the IS-LM curves of John Maynard Keynes).

Yet, as strange as it may seem, the world as a whole is in excess savings. How is this possible since we have been reading and hearing everywhere that the states and households are over-indebted? Well there are 3 types of players that drive the rise of the world saving.

-Savings rates remain extremely high in Asian emerging countries, Japan and oil producing countries. At the risk of shocking, it is almost as worrying as the opposite situation of savings deficit we have in Europe and US (after all this means that these emerging countries are developing poorly and do not invest in adequate development infrastructure and social protection system, favoring a financial logic of no-revaluation of their currencies by buying government securities denominated in USD, GBP or EUR... Until when? It is the whole problem of the balance of international capital flows that is here posed).

-The household saving rate also rises in the U.S. (from 1% to 6% of household income in 2 years), in Europe (from 14 to 16% of income), and Japan as well (due to fear of unemployment and debt paydown).

-Finally, companies (everywhere in the United States, Europe, Japan) are making huge profits with a share of value added which continues to emphasize the shareholders at the expense of wage-earner (if profit is essential, it must smartly be reinvested economically and socially)

We are in an economically absurd situation of excess savings with low investments in large corporate (self-financing rate exceeds 100% in many countries; although the trauma of the closure of bond market access in fall 2008 is still in many corporates mind, in no way it justifies accumulation of profits not reinvested and saved ...)

What could lead a rise of long-term rates ??

Today the management of a bank’s balance sheet is complicated. We know that the two major interest rate risks to handle are:
-Risk of rising short-term rates with a higher cost of refinancing long-term employment at fixed rate; this risk is minor because of reasons mentioned above (low probability of rising central banks key rates, and thus an ascent of short-term rates)
-Risk of falling long-term rates with lower profitability of commercial bank on the future production of fixed-rate loans. This risk is the major risk of a financial institution (to be convinced, it would be fun to interview leaders of Japanese banks over the last 20 years and they could explain how the Japanese banking system was destroyed by keeping sustainably low long-term rates).
Fortunately, there are derivatives, hedging long-term rate risk, that generate almost systematically net margin gains in an environment of low long-term rates and compensate for the shortfall in fixed-rate loans production.
Unfortunately bankers are more likely to cover their risk of rising short-term rates than the one of declining long-term rates: it must be said that market consensus and budget forecast scenarios have always showed a systematic bullish bias on growth and inflation, hence bullish in short-term and long-term rates. The misfortune is that political correctness is often deficient.

And very often, long-term rates hedging positions are difficult to justify in an accounting perspective (because of IFRS rules, often designed by regulators without any knowledge on the management of bank’s balance sheet, even if the macro-hedging justification is obvious economically and financially).

Given the pressure of auditors, who may assign these hedging operations to speculation, bankers can choose - unfortunately rightly -not to hedge. Long-term rates should not be sustainably low as it could end up costing a lot to banks ALM (asset liability management).

So the real question today is whether long-term rates can go up and if yes, when ?, how and why?
Amongst the reasons driving down long-term rates today, many will last for a while
-Indeed, the extra-economic phenomena (risk aversion and regulatory changes) are here to stay
-The global savings glut will persist
-Central banks will not raise their key rates "anytime soon"

The only factors that could help long-term rates to rise, are linked to emerging economies

1 / inflationary risks in emerging economies when there will be pressure on production capacity:
A requirement for excess liquidity to lead to inflation, is the return to full capacity use (insufficient resources in skilled manpower, slowing productivity gains).
These inflationary pressures will be exacerbated by rising wage costs (see the current case of China, which lead to a real sharp appreciation of the Yuan unlike to what one reads everywhere).
This macro situation will send inflation to Europe and the United States and could be the source of pressures on long-term rates. Difficult to know when this will occur ... In 3, 5, 7 years?

2 / Exchange rate regime less source of liquidity
So far, emerging countries and commodity exporters have been buyers of treasuries, therefore dollars buyers, in order to stabilize their exchange rates and remain competitive. We know it’s a key reason for keeping long-term rates at very low level
Tomorrow (in 3, 5, 7 years?), The global exchange rate regime will less contribute to liquidity increase than in the past, with the probable change of regime in China which shall move from pegging to dollar to yuan appreciation (against dollar or a basket of currencies), as its growth model will rely more on domestic dynamic growth as than a dynamic linked to exports ( as nominal revaluation of the yuan is no longer a problem for Chinese authorities). The support of dollar will be part of the past and US long-term rates (and Euro by sympathy) will rise... Meanwhile, long-term rates are unlikely to rise, the risk being a further decline!

Mory Doré November 2010

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