The Great Two Horse Race

15th May '09 by pennant

16 comments 6405 reads

For credit crunch read rise in interest rates. By the law of supply and demand if there is less credit about then everyone has to pay more for it. So why are interest rates staying low? Because a fortune is being pumped into creating credit in the economy by increasing goverment debt and printing money. The trouble is that these interventions will themselves raise interest rates in due course because the risks associated with holding Government bonds rises in proportion with the debt as a proportion (or multiple) of GDP.

So we are witnessing a great two horse race. One horse is called Growth and the other is called Interest Rates: The Goverment is hoping that it can stimulate fast enough and strong enough growth in the economy before an inevitable rise in interest rates overwhelms any chance of an early end to this recession. Which horse are you backing? Not the one with tartan colours and one blinker I hope!

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emptyend

16th May '09

I can't see that the Government's growth forecasts stand any chance of being right.

I'm very much in the "anaemic recovery" camp, with consumer spending and property-related spending continuing to be under the cosh (I notice yet more closures in our local High Streets). OTOH the squeeze will also be trimming investment, so I'm very happy to continue to bet that resources are a good way to hedge the incipient inflation risk.

FWIW

Gradders73

17th May '09

It seems certain we are seeing a desperate attempt to keep a lid on bond yields as the markets are fretting about the volume of new issues coming this year and next. They have thrown most things at it, rates almost zero, buying up govies and corporate debt, and the recent announcement "inflation" will stay below 2% until 2012. Each time, the bonds rally but then fall away a bit further than before. In theory, they can keep a lid on bond yields to a certain degree, but the currency will suffer and I suspect they will then say, it's not really inflation that we can do anything about because it's import driven. Truth is, government spending is shooting up and tax revenues are down. They either increase tax rates (unfortunately, this would drive away many corporations who pay precious little tax as is) and is politically unpalatable, or they tax via the inflation route.

The historic low interest rates are not really benefiting borrowers anyway, as spreads are so high - what we are seeing in UK and US is money being fed to the banks to get them back on their feet. They are promising low rates for 5 yrs, so please buy our bonds!

But, if growth does start to return, investors will switch out of bonds and yields will go up and then rates will rise and growth will be hampered. It is such a tricky course to plot. Other thing is the performance in UK Gilts will be influenced by how bad Euroland gets and the risk that the US could crowd out all other central banks.

My big concern is that the actions of the central banks in US and UK are sensible for economies with strong manufacturing bases and postiive balances of trade, but are doomed to fail with consumption making up such a high proportion of GDP and external debt.

18th May '09

This is a very interesting analysis - I see us heading to option 6 then maybe to option 5, depending on how much the surplus nations want to hurt us, as the leaders throw their hands up and say we did what we could....

The problem is option 2 may be the sensible choice, but whoever pushes for it is guaranteed to lose the next election (a la Carter or Wilson)...

http://ftalphaville.ft.com/blog/2009/05/18/55977/bible-code-finance-edition/

hugoc

The pessimistic estimates for Government bond issuance worldwide over the next five years are so enormous as to be unfundable without very large increases in yields. Such increases would destroy the value of existing government bonds and torpedo stock market valuations.

Everyone knows that governments will aim slowly to devalue their debt by allowing gentle inflation. Easier said than done. The idea that inflation can be managed within tight limits is not borne out by history here or anwhere else.

The bond markets will be watching like hawks and will punish the first government that goes down the path with a bond strike.

28th May '09

The Treasury market in the US is getting ugly. There were big drops at the longer end yesterday. Bond yields are back to the levels they were before the QE announcement. 30 yr at 4.65%, 10 yr at 3.75% and the 2s 10s spread at 2.75%!.

What seems to be happening is foreign investors are still buying, but switching to lower maturities for a faster escape. There's lots of talk of this being about inflation concerns, but I think it easier to say it is dollar concerns and the ability to demand higher rates when the debt rolls over. I don't believe the Chinese will suddenly dump Treasuries - they aren't that stupid and it is not the time to play the trump card. They will want to see some genuine action to control the budget (tax rises, reduced govt spending) rather than simply printing money and saying it will all be better soon. The weird thing is that Americans seem to prefer to let the economy collapse and face hyperinflation than pay more tax. They also seem to think the problems are about the government budget, rather than the wealth-distributive actions of the private sector. I suppose we need to remember, Herbert Hoover's actions were popular until it got bad enough for FDR to force change.

Anyway, sorry to say it, but I don't think Obama really gets it and is trying to please everyone. Geithner seems out of his depth and lacking the courage to stand up to the banks. The first thing they need to do (but won't yet) is close the derivatives market, to stop people (like me) shorting Treasuries. The Chinese must be somewhat concerned that the Americans tell them Treasuries are still a great investment, but seems like half the US population has short positions. The short selling rule was introduced for banks, why not bonds?

The main consequence of the sell off in Treasuries is that some 30 yr mortgage rates jumped from 5% to 6.5% in a day, I repeat in a day! Bernanke's dream of keeping long terms mortgage rates at 4% in order to get the housing market back on its feet is bust.

The obvious concern is the government spending is out of control and the solution applied to everything is throw money at it. We are reaching a fork in the road. In one direction lies hyperinflation and or default, in the other lies higher taxes, reduced govt spending and asset disposals. The IMF has been very good at forcing these changes upon smaller nations when they have similar problems, but I am not sure anyone has the strength of will to force this on the US. But, there is no easy solution, the day of reckoning is near at hand.

On a slightly lighter note, this could actually be good for UK. The desire for diversification should be attractive for Gilts and there is a general perception that the UK will raise taxes if this becomes necessary.

doverbeach

The first thing they need to do (but won't yet) is close the derivatives market, to stop people (like me) shorting Treasuries.

which would impact the financial system as much as letting Lehmans go under.

The Chinese must be somewhat concerned that the Americans tell them Treasuries are still a great investment, but seems like half the US population has short positions.

and banning short selling would encourage the Chinese to think that Treasuries are a good investment?

The short selling rule was introduced for banks, why not bonds?

I think you misunderstand the importance of government bonds for the financial system. Bank equities are very minor by comparison. besides the rationale for banning short-selling of banks was not to protect equities but to prevent runs on banks.

This could actually be good for UK. The desire for diversification should be attractive for Gilts

huh? The pressure on Treasuries is coming because of expectations about the amount the US government will have to iisue. And exactly the same is likley to apply to Gilts.

Gradders,

One of the issues is certainly the inflation outlook - the US long end is going to be under pressure whilst inflation fears (justifiably, IMO) persist. And, as you say, a massive jump in mortgage rates will worry many housebuyers - and mortgage-holders who have delayed their refinancing!

However, AFAIAA (though it is now some years since I saw the evidence first-hand) the Chinese interests in US debt are primarily concentrated at the short end. The Japanese were more focused on the long end, though generally Treasuries have historically not been the investment vehicle of choice, due to low yields ralative to corporate debt etc. Accordingly I'd see long rates as primarily being determined by domestic US considerations re the outlook for inflation and the economy.

I'm not convinced by the argument that the UK might benefit, though it may very well be the case that being "a pimple on the elephant's backside" in terms of the UK's financing requirements relative to EEC/US needs, may help the UK get more than its fair share of international interest in circumstances where people worry about the health of EEC/US. Its a high risk game though - any sniff of a lack of attention to the need to raise taxes and pay down debt could quickly have the opposite effect and cause a fresh run on sterling and gilts!

Doverbeach - I should clarify my statement somewhat. I think they will need to consider controls to limit the amount of short selling of bonds, specifically Treasuries. I realise this would have a huge impact on the financial markets and would need to be done using some variation on the naked short selling rule, but similar things have been done before (albeit in smaller economies). I am aware of the impact on the financial sector (I've got the scars to prove it), but the fact is, everything that has been done to save the financial sector has shifted all of the risk to the state and it is reaching a point were the very country is at risk. If you think there's $220bn of new issues this week, but then add on another 10% of derivative shorts, this is creating an enormous strain. It's not about saying it is a good investment, it is about adding downward pressure, as happened with banks. This is about protecting a run on Treasuries, which would make the Lehman debacle seem like a Sunday picnic.

When I say the aversion to Treasuries may be good for Gilts, I mean in relative terms. The simple truth is, there is a lack of anything to buy if the world dumps Treasuries, and simply converting to Dollars will accomplish little if the US is facing a default.

I know it sounds rather conspiratory, but nobody has audited the Fed. We don't know for sure what positions they have taken on, though the rumours are terrifying. This is the scene in the film, were the poker player has pushed all his chips into the centre of the pile and is eyeing his cards as if to say, "you don't want to bet against this hand."

US mortgage delinquency rate 9.12%. One in eight households now either late with mortgage or in foreclosure.

2nd Jun '09

I really do stand by what I said re US funding crisis helping the UK. If you look at the day that S&P put UK on negative watch, not only did Treasuries fall much furhter than Gilts, but the UK was still able to get away the largest single issue without any problem. Sterling continues to rally relative to USD and Euro, the Gilts are staying quite stable and the economic data from the UK are ok.

I am not saying for a second that everything is hunky-dory in UK, but they are, if anything, worse elsewhere. As an aside, in my travels and discussions, one thing is very clear - the middle classes in various countries (Germany, US and UK) are convinced that the situation is worse in their country than elsewhere.

In Euroland, Mrs Merckel is complaining about central banks buying debt, but the debt crisis in the Club Med nations has got a long way to run.

What seems to be having a major effect is that the party expected to win the next election is publicly stating that they will make the hard decisions necessary to balance the budget, i.e. cut spending and raise taxes, rather than trying to buy votes with tax cuts.

Also, the Chinese have publicly stated they are not investing in Gilts, which as I learned over the years, usually means they are doing. What I can say is given the moves in currency, somebody's buying British...

rpcroft

Regarding the pound Gradders, it seems to me that it follows the direction of equities. If a German pension fund wishes to invest in a Russian oil company or a Chinese airline then they must buy pounds. If they sell these equity investments they most likely take the proceeds home too and sell pounds. This, as well as the UK being geared to financial activity, correlates equities and the pound.

One counter intuitive implication of higher government borrowing is that it often strengthens the native currency due to the foreign buyers. (Unless or until the money printing sins of the host government catch up with it.)

Regarding your Chinese insight, i had a similiar thought as to why they suddenly announced their gold purchases...i took it to mean that they had stopped. Our genius Brown of course pre announced that he was going to sell our gold, ensuring we got the bottom tick of the last 30 years.

stopthenewworldorder

12th Jun '09

rpc brown sold the gold in a series of auctions much to the amazement of the commodity traders who were asked to advise on the sale - all this was to guarantee the bottom tick - that was the whole point ....it is critical to manage the gold price in a paper currency system. to understand this better read the paper by the utterly disreputable Larry Summers of modern political infamy:

http://ideas.repec.org/p/nbr/nberwo/1680.html

At the time, not many people felt gold was going anywhere, so no real feeling that it was absolutely the bottom. I felt at the time, it was more done in order to raise cash for Tory style pre-election tax cuts. Clearly, in hindsight, it was a mistake.

The markets are a bit hazy at the moment. I think the markets seem to be desperate for positive news. take this statement from the Fed Beige Book:

"Reports from the twelve Federal Reserve District Banks indicate that economic conditions remained weak or deteriorated further during the period from mid-April through May. However, five of the Districts noted that the downward trend is showing signs of moderating. Further, contacts from several Districts said that their expectations have improved, though they do not see a substantial increase in economic activity through the end of the year."

Therefore, conditions are clearly worsening in 7 out of twelve districts and only showing signs that the downward trend is moderating (well you stop falling when you hit the ground.) And "expectations" have improved, again this is rather an empty statement.

When you know how much of a positive spin they are trying to put on things, if this is the best they can manage, you know the situation is pretty dire.

Prices rose on the back of this good news!

Stopthenewworldorder

i dont think we can make excuses for many of Brown's actions, least of all a " he got bottom tick because he was trying to.." excuse for his Gold sales. The management of the gold price was not a priority in the 90s, it wasnt even on the radar as it is only a consideration in an inflationary environment and when its price is trending up.

Incidentally, on the subject of the Chinese, I am (fairly) reliably told that the Chinese Central Bank has recently been buying commodities directly - especially stuff like copper than can easily be stockpiled. This fits with the comments made here:

http://www.commodityonline.com/news/China-construction-boom-and-rising-base-metals-18478-3-1.html

Meanwhile, former Chinese central bank adviser Yu Yongding was more direct. "I wish to tell the U.S. government: 'Don't be complacent and think there isn't any alternative for China to buy your bills and bonds','' Yu said in an interview yesterday. "The euro is an alternative. And there are lots of raw materials we can still buy.''

IF this is true, of course (and there is certainly some chatter in the press on the topic too), then it represents a major departure from normal Central Bank practice - and is highly dollar negative, rates negative (so equities negative too) and commodities positive IMO.

15th Jun '09

The general sentiment seems to be designed to scare investors back into Treasuries. The 30 yr bond auction, was the first long dated one for a while and was well bid, with what has been stated as firm interest from foreign central banks (c. 50%). However, this was only a relatively small issue of $11bn and the wording is always vague - the classification is "indirect bidders," the group "which includes central banks" (but could in fact be secret funds set up by the Fed). With the FOMC meeting this week to decide on policy (expect no change in rates outlook for the immediate future, they may state rates to be kept low for next 12mths) decisions on whether to increase the $300bn of QE, maybe switching from purchase of MBS to Treasuries (makes sense, the housing market is not going to bounce back that quickly), maybe doing purchase more slowly. The overall aim will be to boost Treasury prices further, to maintain the demand for the trillions to come. The big question is who will be buying, the answer is the banks, with the cheap funding they get from the Fed (QE via proxy), which is why they won't tighten and why they aren't worried about inflation (or rather why they know monetary stimulus won't cause it) because they money doesn't get into the wider economy.

Markets seem more concerned about deflation that inflation right now. I suspect we will see both - continued asset deflation and consumer and raw materials inflation (which strains profit margins and hence hurts investment assets), but no official inflation, as the knock-on costs to govt and business would be a killer.

This weak, I expect to be all about Dollar and Treasuries strengthening vs equities and commodities.....

Anway, keep an eye on the chaos in California, how they manage to reduce govt spending may become a benchmark for the economy as a whole.

Don't know if people saw this story.....

http://atlasshrugs2000.typepad.com/atlas_shrugs/2009/06/talys-financial-police-seize-us-1345-billion-us-bonds-on-the-border-between-italy-and-switzerland-sm.html

The Great Two Horse Race

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Pennant

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