What Are the Bond Markets Trying to Tell Us?

What are investors in the bond markets trying to tell us?  To me, we must give some kind of interpretation to where current yields are in order to get some idea about where financial markets believe that the economy is going.

Historically, one could take an estimate for the expected real rate of interest and add to this one’s expectation for inflation and come up with a projection for what the nominal rate of interest on United States Treasury should be. 

In today’s environment this is problematic.  In the past a good proxy for the expected real rate of interest was the expected long-term growth rate of the economy. (Equating the expected real rate of interest with the expected long-term growth rate of the economy has the backing of the accepted economic growth theory and has worked on a practical basis.)

Whereas in the past one could estimate the expected real rate of interest at around 3.00 percent since the expected long-run rate of growth of the economy could be around this number. 

Being a little more conservative let’s say that the expected real rate of growth of the economy in the near term will be around 2.25 percent. (http://seekingalpha.com/article/503181-economic-growth-will-continue-entering-the-next-stage) Given the rule presented above this means that we could expect that the real rate of interest in the economy should be around 2.25 percent.

Now, the current year-over-year rate of increase in the GDP implicit price deflator is 2.1 percent.  Again, to be conservative, let’s assume that our expected rate of inflation is just 2.0 percent.

This would mean that our estimate for the yield on the 10-year US Treasury bond would be 4.25 percent even given our very conservative estimates of the real rate of interest and inflationary expectations. 

This forecast is problematic because the current yield on the 10-year US Treasury bond is around 2.00 percent. 

 The problem that we are dealing with at the present time is that the United States is experiencing an inflow of funds from the rest of the world due to a “flight to quality” coming from the continent of Europe.  In this “flight to quality” investors are not looking at earning a sufficient amount of return to earn themselves an inflation protected real rate of interest.  These investors are looking primarily for a “safe haven” in which to place their funds and earn something more than they would earn keeping their funds in cash or very short-term securities. (http://seekingalpha.com/article/507891-u-s-treasuries-still-a-safe-haven-and-yields-on-tips-remain-negative)

 

This “flight-to-quality” has driven the yield on the 10-year US Treasury security to around 2.00 percent.  This “flight” is the dominating force in the bond market these days.

This “flight” is even dominating whatever the Federal Reserve is doing these days.  The interpretation here is that the supply of funds coming into the US market is keeping these interest rates so low allowing the Fed to do next to nothing in keeping US interest rates so low.  (http://seekingalpha.com/article/519961-don-t-expect-qe3-from-the-fed-this-week) This, of course, is taking some of the pressure off Fed Chairman Ben Bernanke. (http://seekingalpha.com/article/542361-economic-growth-for-the-first-quarter-good-scenario-for-bernanke)

Bond holders, however, want to be protected from the deterioration of the real value of their bonds so they are still asking for protection against the inflation they expect to face in the future.  That is why the yield on 10-year inflation-protected Treasury issues (TIPS) have been paying a negative yield.  This negative yield is around 0.30 percent. 

Thus, if one subtracts the yield on TIPS from the yield on the 10-year issue from the yield on the 10-year Treasury bond, one comes up with the market’s current estimate for future inflation.  At this time expected inflation is around 2.30 percent, a little above the current rate of inflation cited above. 

Note that the yield on TIPS became negative in early August 2011, when the European sovereign debt crisis picked up once again specifically relating to the events in Greece.  The concerns over Europe continue with the emphasis now shifted to Spain.       

In terms of the future, I would argue that the negative yield on TIPS bonds will not become positive again until the European situations eases enough so that funds will start returning to “riskier” debt in Spain, and Portugal, and Greece, and Italy.  As these funds begin to flow out of the US Treasury market, yields will begin to rise and historical relationships will return. 

What I am saying here is that if TIPS rise to around 1.00 percent, the level of earlier 2011 as seen in the accompanying chart, and inflationary expectations remain at even 2.00 percent, the yield on the 10-year Treasury issue should rise to at least 3.00 percent. 

If the economy continues to grow at a rate in excess of 2.00 percent and inflationary expectations remain at the 2.00 percent level, the yield on the 10-year Treasury issue should rise to at least 4.00 percent.

The European debt crisis is having a major impact on US bond markets and yield relationships and will continue to do so until European officials really resolve their fiscal problems.  Thus, look for what happens to the yield on TIPS in the near future.  That will provide information on what the financial markets think about European prospects.

Given this scenario, the next pressure point for the Federal Reserve will occur when the Europeans do resolve their financial issues.  Then the Federal Reserve will be faced with having to deal with rising interest rates and this will make its life just that much harder.   

Europe Still Bubbles

The headlines coming out of the weekend: “Italy warns Spain over budget” (http://www.ft.com/intl/cms/s/0/70fbb99c-768e-11e1-a6f3-00144feab49a.html#axzz1qE3JX1ju); “Germany ready to boost size of firewall” (http://www.ft.com/intl/cms/s/0/85911faa-767f-11e1-8e1b-00144feab49a.html#axzz1qE3JX1ju); Europe’s bailout bazooka is proving a toy gun” (http://www.ft.com/intl/cms/s/0/3e736dd2-74d9-11e1-ab8b-00144feab49a.html#axzz1qE3JX1ju); “Greek bond yields jump as trading in credit default swaps put on hold (http://www.ft.com/intl/cms/s/0/55db7e7e-74ca-11e1-ab8b-00144feab49a.html#axzz1qE3JX1ju).”  And so on, and so forth.

Bets on Intrade.com, recently, put the odds of the European fiscal union cracking apart by the end of 2013 at a little more than 36 percent.

There are all sorts of scenarios that picture the demise of the current arrangement.

But, there is one major thing that seems to keep holding the union together: the fact that the cooperative structure added to the common market has provided the vision of an economic bloc that can be competitive in this modern world with the other major economic areas of the world like America, China, Brazil, Russia, and India.

Combination is better than separation.

Yet, the path to deeper integration and greater centralization of the fiscal authority is ugly. 

One reason for this is that the countries of the eurozone have centuries of history, of wars, of hatred, of irrational biases to get over.

As the recent movements on the Greek crisis showed, the shadow of the past was not far from people’s minds as references to the Nazis and German domination bubbled up into the debate.

The past is not going to be forgotten…and there is a lot of it.

Yet, here in the 21^st century, the economic reality of the situation, I believe, will win out.  The eurozone will hold together for the alternative, small, separate states competing against each other and “biggies” of the world, is not a real choice.  And, most officials in Europe, I believe, realize this.

One continuing problem in the effort is that these European officials repeatedly fail to “get their arms around a situation”. 

The “good” news over the weekend: “Germany is set to bow to international pressure and allow a temporary increase in the eurozone’s financial ‘firewall” this week, to prevent the crisis in the region’s periphery spreading to other member states.” (See “Germany ready to boost size of firewall” cited above.)

The “bad” news: the “rescue umbrella” is not big enough.” (See “Europe’s bailout bazooka…” cited above.)

The “umbrella” may be able to handle any problems coming from the smaller states, like Greece and Ireland, but it would not be able to handle Spain…or Italy.

The Italian prime minister, Mario Monti, is concerned about this and warned Spain that it should not back off from fiscal efforts and weaken its “budget-cutting credentials.” (See “Italy warns Spain…” cited above.)

But, financial markets still reflect the uncertainty about what is happening.  Greek bond yields reached new post-bailout highs on Friday as yields on Portuguese bonds remain quite high and those on Spain’s bonds rose by about 30 basis points toward the end of the week. 

The rise in the yields on Greek debt spilled over to the credit default swaps market as investors showed fear that the CDS trigger process might be subject to some immediate payout problems.  There was additional concern that this issue could impact other eurozone bond markets. 

So, the process of integration continues.  And, as mentioned above, the process is not pretty.

It is hard for sovereign nations to give up their fiscal powers, especially when their elections are so dependent upon the “free lunches” that politicians promise to the voters.  Yet, this is where events are leading.

It is going to be a bumpy road and there are many ways that the “end game” could be played out, but, in my mind, one way or another, the euro will survive and Europe will eventually prosper because of it.       

The Greek Situation: Financial Markets Do Not Like Surprises...and Vice Versa

Greece had a credit event.  Credit default swaps were triggered.

Markets opened.  Markets functioned.

This morning, the “new” Greek debt was trading at distressed levels…just below 20 percent.  The read of the market, “investors are braced for more distress.” (http://www.ft.com/intl/cms/s/0/d5440e3c-6c29-11e1-8c9d-00144feab49a.html#axzz1ouHDWdzj)

But, the world did not end. (http://professional.wsj.com/article/SB10001424052702304537904577275462837459448.html?mod=ITP_opinion_2&mg=reno64-sec-wsj)

Concerns still remain about Greece and the Greek government: “Most investors remain deeply skeptical of Greece and the sustainability of its debt despite Athens shaving off €100bn, or nearly a third, from its debt burden in last week’s successful bond swap.”

Financial markets are going to want to test this.  And this may mean that the “downside” of the pricing of Greek bonds may initially be pushed to see how firm it really is.  Whether or not the downside holds will depend upon what the Greek government does in upcoming weeks and what the eurozone does with respect to its lingering problems.

This concern does extend beyond the Greek situation in that the yield on the 10-year government bonds of Portugal, the country deemed most likely to follow the example of Greece, remains near the high levels reached in the recent unsettled weeks.

This situation, I believe, raises the question as to whether or not the actions taken by Greece are strong enough and will the Greek government actually be able to carry out everything that is needed to resolve the Greek insolvency.

Markets do respond positively to “credible” actions on the part of national governments.  For example, the “technocratic” government put into place in Italy seems, at least for the time being, to have calmed the international investors.  In November 2011, the 10-year bond of Italy was trading to yield around 7.30 percent.  A 7.00 percent yield was declared to be unsustainable for Italy.  Currently, this bond is trading below 5.00 percent, indicating that there is some trust that the present Italian government will achieve what it is attempting to do.

We will, of course, see whether or not these “expectations” play out.

But, as the editorial in the Wall Street Journal suggests, “the world did not end” with the Greek restructuring.

My response here is that markets do not stop trading when events are not surprises.  Markets hate surprises and when they are surprised…trading stops.  In such situations, traders don’t know where to set prices.

We can have policy surprises.  I was at the New York Fed one time when the Federal Reserve decided, for international reasons, to reverse the policy they had been following that had resulted in short term interest rates declining.  The fact that the Fed wanted short term rates to rise and therefore did not intervene when market pressures pushed these rates higher caused the financial markets to pause…trading stopped for a while.  Expectations had been broken and traders had to reset them before trading began once again.

Another example of a “liquidity crisis” is when the Penn Central Company failed.  Here was an example where the market perceived that the Penn Central had top rated credit and expected that the commercial paper issued by this company would be rolled over without any problem.  When the company declared bankruptcy it was a shock to the financial markets because the traders not only had to deal with this new information about the Penn Central itself, but also questions arose about the credit ratings of other highly regarded companies. 

The Federal Reserve had to react to this liquidity crisis by “throwing open the discount window” and other measures to provide market liquidity until traders could feel confident in starting up trading once again.

The recent “unexpected” event that surprised the financial markets and provided the background for the current concern over the creation of another “credit event” was the failure of Lehman Brothers.  Financial markets did not expect the United States government to let Lehman “go under”.  When the government did allow the company to “go under” people were not really prepared for this event…they were “surprised”.  And, systemic risk was released that caused substantial disruption to United States and European financial markets.

Great concern has been expressed in Europe (and elsewhere) that a Greek “credit event” that triggered the payment of credit default swaps could set off systemic effects that would spread from Greece to Portugal and possibly Spain…and Italy…and other countries. 

My feeling is that this concern was excessive.

The Lehman Brothers “event” was not expected.  Since people were not really prepared for the “event” adjustments had to be made, financial positions had to be altered, and, expectations had to be changed.  And, this transition had to take place throughout many, many organizations.

In the current Greek situation, the action taken last week was not un-expected.  Financial markets were prepared for it.  And, the financial markets absorbed the “shock” without much problem.

I believe that financial markets do work and do work well if they are not surprised.  This is why, in my mind, financial markets handled the Greek bond-restructuring program as well as they did. 

I am not convinced that politicians and government officials understand this.

Also, I am not convinced that politicians and government officials understand that their failure to fully resolve issues can create “sure-thing bets” in financial markets.  That is, if the Greek government does not fully execute the restructuring plan and carry out the promises it has made, a lot of people will make a lot more money by continuing to bett against the Greek government.

Just ask George Soros about the British government setting up “sure-thing bets” by trying to maintain the value of the pound in the 1990s.

Europe Hasn't Got It Yet!

The yield on the 10-year bond issued by Portugal jumped by 70 basis points yesterday coming close to a 14 percent yield.

Today, Greek 10-year bonds jumped dramatically to yield more than 38 percent.

Spain’s prime minister begged other officials in the eurozone to ease up on the deficit targets his country is supposed to hit. 

The European Union is being urged to cut the cost of Ireland’s bailout.

800 European banks obtained €530 billion in three-year loans this week from the European Central Bank…up from 523 banks and €489 billion in three-year loans in December 2011.

The head of Germany’s Bundesbank has attacked the president of the European Central Bank, Mario Draghi, over the behavior of the ECB.

France is facing a change in government in the up coming elections.

The European recession continues.

And, protests increase throughout the eurozone.

A system is dysfunctional when the solutions it tries over and over again fail to resolve the problems that are plaguing the system.

One keeps hoping that the pain that the system is feeling will finally become great enough so that the system will try to find a new solution…even if that new system presents a new set of difficulties.

Officials in Europe have continually looked at their situation and provided the diagnosis that their problem is one of liquidity.  Hence, these officials provided more liquidity to their system, first through debt repayment postponements, then through bailouts, then through debt-restructurings, and now through three-year loans to banks to buy time for sovereign nations to get their act in order.

But, the nations that are helped never really deliver. 

No one seems to trust Greece. (http://seekingalpha.com/article/374631-liar-liar-pants-on-fire-the-greek-case) 

Investor’s increasingly believe that Portugal will need a second bail-out.

Ireland is now going to hold a referendum on the fiscal compact of the eurozone.

And, Spain is coming nowhere close to meeting its targets on debt reduction and hence is demanding relief from the targets.

Nothing seems to be holding together. 

So, could it be that maybe…maybe…the problem is one of insolvency and not liquidity?

But, no one likes the I-word.

Liquidity problems can be blamed on that shady crowd of international financial interests and speculators. 

Thus, it is assumed that if sufficient liquidity is provided the markets then this will defeat these “greedy bastards” and everyone can get back to business as usual. 

However if the problem is one of insolvency, this means that the blame must be placed on the governments themselves and the politicians that run these governments. 

But, have you ever seen a politician take the blame for anything?

No standing government will ever take the responsibility for creating a fiscal crisis.  But, that is what we have and until some of these governments are forced to accept the fact that the problems that they are now facing exist because they are insolvent we will get no resolution of the problems.

My best guess is that this stalemate will continue because there are no leaders that will step up and declare that “the Emperor is wearing no clothes.”

European officials will continue to fight the fantasy of illiquidity.  And, they will continue to fight this fantasy even as the recession they are facing worsens.  That is what a dysfunctional system does.

To continue this fantasy, we learn that the International Swaps and Derivatives Association has declared that in the Greek situation there has not been a “credit event” and thus the credit default swaps associated with the Greed debt cannot be exercised.  Where is Walt Disney when you need him?

Greece: Initial Response to the Latest "Kick of the Can Down the Road"

The eurozone has acted.

Greece is going to postpone bankruptcy for a while longer as it was given 130 billion euros to help it cover, among other things, debt coming due in March. 

Problems still remain.

First, Greece is still insolvent.

Second, Greece still has major structural problems in its economy and society.

Third, Greece is in a severe recession.

Fourth, the eurozone is in the midst of a recession.

Fifth, 90 percent of the holders of Greek debt must sign up for the bond swap.  If they don’t there may be severe legal problems.

Sixth, the Greek government must still implement the policies and programs required by the bailout plan.

Seventh, Greek society must hold together.  The question still remains about how the Greek people will “suffer” the policies and programs required by the bailout plan.

Eighth, elections for a new Greek government will be held in April.  There is uncertainty about what will result from this election. (http://seekingalpha.com/article/374631-liar-liar-pants-on-fire-the-greek-case)

Ninth, there is concern over what is going to happen in the Middle East.  The focus is on Iran, Israel, Europe, and the United States.

Tenth, enough said, given all the other problems and uncertainties in the world today.

Bottom line: the major issues outstanding have not been dealt with; there is little or no confidence in the officials in charge; and the world needs to move on but still has the Greek problem to deal with.