Global: Losing Control -- Stephen Roach (New York)
morganstanley.com
Jul 22, 2003
The current rout in the US bond market is starting to reach epic proportions. Yields on 10-year Treasuries have backed up an astonishing 108 bp in just five weeks. Given the record low yields that were prevailing on June 13 (daily close of 3.11%), this sell-off is far worse on a percentage change basis -- a 35% surge in long-term government interest rates. It’s a carnage that is now taking on the trappings of the worst sell-off of them all -- the great bond market rout of 1994, when yields on 10-year Treasuries rose by 44% (or 246 bp from 5.57% in January 1994 to 8.03% in November 1994). Needless to say, if the rout continues, all bets could be off on other asset markets, to say nothing of the nascent recovery in the US economy.
What happened? No one wants to accept blame for bad things -- least of all the Federal Reserve. But America’s central bank is hardly an innocent bystander in the extraordinary volatility that has afflicted the bond market. A deflation-fighting Fed initially encouraged the markets to accept two key premises -- the first being it that it would not repeat the mistakes of the Bank of Japan and take its policy rate to “zero.” Second, the Fed went out of its way to assure market participants that it had an ample arsenal of “non-traditional” policy tools available to fight deflation should it run out of conventional ammunition. At the top of the laundry list insofar as non-traditional remedies were concerned was the distinct possibility that the Fed would make direct purchases of long-dated Treasuries. As its deflationary concerns intensified in early May, the US central bank did little to dissuade market participants that such actions might have been the offing. Largely on the basis of those expectations, there was a stunning rally at the long end of the US Treasury market that took yields to record lows in early June. The market remained a believer right up to the eve of the Fed’s late June policy meeting. On June 24 -- the day before its policy pronouncement -- yields on 10-year Treasuries stood at 3.25%.
And then the world tilted. Actually, it all really started with a late-June article in the Wall Street Journal (“Next Fed Rate Cut May Be Smaller Than Expected” by Greg Ip on June 20, 2003), which suggested that the Fed’s research staff was having second thoughts about the non-traditional tactics involving direct purchases at the long end of the Treasury yield curve. The Fed went on to ease by only 25 bp on June 25 -- an action that not only fell a bit short of a more aggressive move that had been priced into fixed income markets but one that failed to pay any lip service to the issue of non-traditional easing. Then Chairman Alan Greenspan made matters far worse in his semi-annual policy statement to the Congress in early July. By stating that that the Fed still had plenty of leeway for a substantial easing of its traditional policy instrument, he changed dramatically the operative assumption on the lower boundary of the federal funds rate. Previously, we had been led to believe that the Fed would be reluctant to go through the 50-75 bp threshold on the funds rate. Now it seems as if the Fed would be willing to entertain the possibility of a BOJ-like “zero” federal funds rate target, should circumstances so dictate. With markets now convinced that traditional policy options were likely to be on the table for much longer that previously expected, it seemed reasonable to conclude that the non-traditional option of buying the 10-year deserved a lower probability. And then the rout was on -- a massive unwinding of the “deflation trade.” From the eve of the Fed’s policy announcement on June 24 through the July 21 close, yields on the 10-year have surged some 94 bp.
There are a number of alternative explanations to this dramatic sell-off in the bond market. There are those, of course, who claim that signs of incipient economic recovery have turned the bond market inside out. While I’m hardly objective on that point, even the diehard growth optimists concede that the evidence remains mixed at this point and that the vigorous recovery call is still a forecast (see Dick Berner’s July 18 dispatch, “Recovery Signs”). Others have argued that the rapidly deteriorating federal budget deficit is the culprit, sparked by the administration’s midyear confession that the budget shortfall is likely to hit $455 billion in the current fiscal year. While I would be the last to minimize the significance of this development, it hardly qualifies as the singular surprise that can explain the bond market’s extreme gyrations over the past few weeks. In my view, this sell-off has the fingerprints of the Fed all over it. Maybe it’s all a coincidence that this chain of events unfolded at the same time that Fedspeak reversed course. But I doubt it.
As to where the bond market goes from here, my advice is to ignore the economists and listen to the traders. It’s been my experience that huge market moves like this have little to do with fundamentals and much more to do with market technicals and trading dynamics. The very concept of “fair value” is utterly meaningless at times like this. I am still scarred by my futile efforts to make sense of the bond market carnage of 1994. Even so, I can’t help but note that long-term real interest rates of 2.2% (as measured by the 10-year TIPS) are still well below average (3.5%) for a recovering economy with outsize budget deficits. In other words, if I’ve got the recovery bet wrong, even the economics suggests that there’s still plenty of upside to yields from current levels.
But here’s where I defer to the traders. Their tone is starting to sound very similar to that which was evident some nine years ago. As was the case back then, there’s great concern today over selling pressures stemming from mortgage “convexity.” And yet today’s US economy is actually far more dependent on the infrastructure of home mortgage financing and refinancing than it was in 1994. According to Federal Reserve data, mortgage debt outstanding is currently about 67% of GDP; by contrast, in 1994, the ratio was 48%. If anything, that suggests there could be an even more powerful convexity-related unwind this time around. The traders today are telling us exactly what they did back then -- the more rates back up, the more the long end gets hammered by an unwinding of mortgage-related hedging. It’s a warning we have to take seriously.
But that’s not all. One of my most seasoned trader compatriots has always warned that a yield curve which “steepens in a downtrade” is emblematic of the most virulent of bear markets. And that’s exactly what is going on today. The spread between 2s and 10s in the Treasury market hit 259 bp at the close on 21 July -- equaling the yield gap last seen in 1992. The traders are telling me that this “bear spasm” is now at risk of feeding on itself -- until or unless it is stopped by an unexpected weakening in the economy or by direct intervention by the authorities.
This is hardly an outcome that the Fed, or any of us, would deem desirable in the current climate. It runs the very real risk of spilling over into other asset markets -- especially given the mounting potential for an a further sell-off in the US dollar as part and parcel of America’s long overdue current-account adjustment. Moreover, a sharp additional back-up in long rates poses a serious threat to a nascent recovery in the US economy -- not only crimping the credit-sensitive sectors of homebuilding, capital spending, and consumer durables but also aborting the home mortgage refinancing cycle that has been so supportive of consumer demand. We tend to forget that the US economy is still closer to the brink of deflation than inflation. Wouldn’t it be ironic -- and tragic -- if the perils of deflation were compounded by a rout in the bond market?
In my view, all this is indicative of what happens when deflationary risks of post-bubble economies take monetary policy into uncharted waters. As short-term nominal interest rates approach zero, central banks start to lose control of financial markets and the real economy. That’s precisely what has happened in Japan under the BOJ’s zero-interest-rate regime. And the rout in America’s bond market may well be a warning sign of a similar fate for the Fed. |
