Glad you asked, definitely worth a post. From CI's 4/1 "Flock of Siegel's" one of their best recent essays:
A Flock Of Siegels...These days, maybe we scan the Wall Street Journal if we can scrap together a few free minutes. We literally don't have the time to plow through it page by page. No matter, by the time news hits the Journal in today's wired world, it's already old. But one tiny article did catch our eye on Tuesday. It was an op-ed piece written by the infamous "stocks for the long run" Jeremy Siegel. But this go around, Siegel was essentially justifying Greenspan's 1% wonder Fed Funds rate based on the fact that longer maturities in the bond market have been so well behaved as of late, despite commodity price blasting caps going off around them on a daily basis. Who knows, maybe Siegel is preparing a financial market sequel - "Bonds For The Long Run". Yeah, we can see it now. Of course it would be nothing but perfect timing. First a few quick quotes from professor Siegel and then on to our view of the reality of life.
"But if monetary policy were really too accommodating, wouldn't we see rising interest rates in the bond market? Yet with the 10-year bond yield under 4%, we see no such concern. Are those calling for higher rates saying that the bond vigilantes - who have kept government and the Fed honest by pushing bond prices lower when the Fed's action has been inflationary - are flat out wrong? That would be a sharp reversal from the past when the bond market was routinely praised for warning errant governments of monetary and fiscal policy profligacy."
"We can argue that the long-term real rates are too low and investors are too pessimistic about long-term growth prospects. But the bond market is saying, Yes, I know that current GDP growth is quite good, but I don't believe it will last. If the markets are in this frame of mind, Mr. Greenspan is right to maintain the current policy and runs a high risk by raising rates now."
In no way are we going to suggest that Siegel is dead wrong, but rather it sure appears to us that Siegel is making one big heroic assumption. And that assumption is that we are currently operating in what might be considered a normal bond market environment by historical standards, let alone experiencing a normal economic recovery cycle. We suggest something quite the opposite on both accounts. We propose to you two lines of thinking. First, we believe what we are seeing in the bond market of the here and now is anything but what would be considered normal from a greater macro historical standpoint. Secondly, we'll leave you with one other pleasant thought. And that is that we believe the strong potential exists for volatility in forward interest rate movements unlike anything seen in recent financial history.
We Don't Need No Stinkeen' Badges... It's our belief that the "bond market vigilantes" of yesterday that Siegel refers to are simply being outgunned in the current environment. They are simply no match for the modern day technological warfare of liquidity creation and its attendant price fallout on asset classes of all types. And like chief vigilante Bill Gross at Pimco seems to have accepted in his own personal account, when outgunned, it's often best to just get out of the way. It's our feeling that in today's world, the vigilantes of yesteryear have simply been replaced by the enormous fixed income carry trade players, the hedge community, the behemoth derivatives giants walking the face of the earth, and the foreign central banks intent on mercantilist driven currency manipulation activities. The bond vigilantes of today supposedly wearing the white hats are the minority relative to this greater majority of speculators whose investment intentions have very little to do with monitoring or pricing in the real or perceived rate of inflation stateside at any point in time.
In good part courtesy of the Fed's accommodation, we presently find ourselves with one of the steepest yield curves on record anywhere over the past half century. As you can see below, an approximate 300 basis point spread between the 10 year Treasury yield and the Fed Funds rate is about as wide as it gets.
And with the combined Greenspan and Bernanke guarantees of continued monetary accommodation patience, it has simply been a green light period for leveraged financial speculation. It just so happens that beneath Siegel's calm and tranquil Treasury market, a volcanic eruption of leverage has been occurring. Leverage that could ultimately be very destructive should interest rates turn up unexpectedly for any reason. Leverage that certainly is one potential catalyst for interest rate volatility of significant proportion at some point down the road. Let's have a quick look at the numbers. What you see below are the net borrowings of primary bond dealers in this country. We're talking a little over $750 billion in total borrowings at last count in early 2004. This is a doubling of system wide leverage in the dealer community alone since year end 2000. This is how the mega brokerage firms on the Street are earning such high profits these days. They are playing interest rate spreads with huge amounts of levered investments. Significantly leveraged hedge funds such as Goldman Sachs, that are basically masquerading as brokerage and investment banking firms, have incredible earnings and capital sensitivity to the bond world, or more correctly to interest rate movements. Firms such as Goldman are after one thing and one thing only, short term profits. Do you really think these folks care about forecasting inflation out further than a few days or weeks? These folks aren't vigilantes, they're highwaymen plain and simple. And these days, we can assure you that there are a lot of highwaymen traveling the back roads of the fixed income markets willing to pick off a vigilante for a few basis points.
We have but one very humble question regarding what you see above. In all sincerity, how does the incredible leverage underpinning bond prices of the moment ultimately unwind without causing at least some type of price dislocation? Honestly, we just don't have an answer. And it's not like the Fed doesn't know this magnitude of leverage exists. They helped foster the darn situation in the first place. There is no question that part of the reason Siegel's longer dated Treasury bonds are behaving so well is due to the incredible presence of the carry trade community (borrowing short and lending long on a leveraged basis). This community is made up of the hedge, brokerage, banking, etc. players. There is a hell of a lot of company on the same side of the trade here. That we're sure the Fed knows. And it probably keeps them up at night in terms of wondering how they will ultimately approach raising short rates without sending all of these collective masters of the universe rushing for the leverage exit door in simultaneous fashion. As a matter of fact, we're wondering the same thing.
The Ultimate Quid Pro Quo?...You already know that the foreign community has been the largest single buyer of US Treasuries (as a block) in most Treasury auctions of the last few years. You also know from our ongoing tracking that the foreign community now holds close to 44% of total tradable UST's. Rate of change in buying since 2000 has been nothing but almost vertical.
The differential in global short term interest rates is quite substantial at the moment. Foreigners (largely foreign central banks) parking capital in short term Treasuries are certainly not in short dated Treasuries for the yield. They could do much better elsewhere. The same deal goes for longer dated maturities. The following table compares the yield on the ten year Treasury (as of 3/31) with like maturity sovereign debt of alternative nations:
Country
Yield of 10 Year UST Relative To Like Maturity Sovereign Debt Of Foreign Nation
Holland
(18)bp
France
(15)
Denmark
(24)
Belgium
(23)
Japan
242
UK
(89)
Italy
(35)
Spain
(15)
Australia
(158)
Sweden
(40)
Ireland
(32)
Canada
(47)
In characterizing the apparent normalcy of the current US Treasury yield curve, Siegel fails to address one teeny tiny factor - the incredibly enormous force that the foreign community, especially Asia, has been in the UST market over the last few years. Once again, a foreign community who is interested in being anything but vigilantes. In fact, alternatively, they are provocateurs in a greater game of global mercantilism. We ask you, what true or possibly last standing vigilante would be stupid enough to get in the way of the Japanese central bank steamroller of UST purchasing? Only gloomy vigilantes with a fixed income market death wish. Along with their UST carry trade brethren, the foreign community is also weighing in on the same side of the trade. It's starting to get a bit lopsided on the long Treasury side of the boat to say the least. And like their carry trade brethren, forward actions of the foreign community may make for significant volatility in rates ahead. If Japan is even close to toning down or ending their currency interventionist activities, the fulcrum will soon begin to shift on the long Treasury trade. We'll just have to see what happens in the months ahead. Although the global capital flow numbers are delayed when released by the Treasury, the daily action of the Yen relative to the dollar is real time. If the Yen begins to strengthen appreciably or without interruption relative to the dollar ahead, we'll know the Japanese central bank is taking one step back from currency intervention which necessarily involves burying their new found dollars in US Treasuries.
As you know, the magnitude of both the in place carry trade and the level of current foreign buying of US Treasuries has no precedent in the history of the US fixed income markets. Yet neither factor are even given the courtesy of a short mention in the Siegel piece. To be honest, simply hard to believe. Even harder to believe that Siegel implicitly sees the current bond market environment as normal. For ourselves, the Siegel comments ring hollow. We consider them shallow at best. Oh well, comments from one Siegel just aren't going to do the trick for us. Who knows, maybe it will take a flock of Siegel's to do the convincing that all is well and fully discounted in bond land.
The Listing Ship...Very briefly, and in conclusion, the large carry trade crowd and the foreign central bank fan club are all on the same side of the Treasury trade as we speak. They are both long in a big way. Hence, the directional US Treasury investment ship is leaning to one side more than noticeably. Will all of these players be allowed to reconcile their unidirectional bets painlessly when the day arrives that short rates begin their upward creep? We sincerely doubt it. Never, in our feeble memory, has so much levered money been on one side of the fixed income market. A unidirectional trade that is ultimately unsustainable, let alone unstable. Finally, and very quickly, the icing on the unidirectional interest rate bet of the moment is the incredible leverage inherent in the US banking system derivatives complex. You'll remember the chart below from our past discussions. Interest rate derivatives make up the bulk of US banking system derivatives exposure. As short term interest rates ultimately move higher, there is no question in our minds that in place interest rate driven derivatives bets will ultimately need to be hedged themselves given the unique, non-exchange traded, nature of these vehicles. And that hedge will take place in the world's most liquid fixed income market - the market for US Treasuries.
Maybe we're going to be incorrect. In fact we hope we're dead wrong. Unfortunately, what we see at the moment is that the financial market table is absolutely set for perhaps incredible interest rate volatility ahead. Of course the big question is when and of what magnitude. One thing Jeremy Siegel is dead right about is his comment that, "(Mr. Greenspan)...runs a high risk by raising rates right now". Hey Jer, quick question. Given the magnitude of current leverage carry trade activities, massive support of the US bond market vis-a-vis foreign buying, and the existence of $70+ trillion in largely interest rate driven US banking system derivatives exposure, just when will it be the right time to raise short rates? Maybe you could address that in your next op-ed piece, huh? |
