Wednesday, May 27, 2009

Some Thoughts On Yields, Spreads, And The Like

In light of today’s sell off on the long end of the curve, it is appropriate to ask at what point the increase in rates could jeopardize the prospects for economic recovery.

First of all, it is far more important what is happening to spreads in private markets than what is happening to the yield on long term government paper. Corporate bond rates have been declining thereby outstripping the negative effect from the increase in government bond yields. As long as corporate and other private market spreads keep contracting, the rise in government bond yields will not matter much. Indeed, they are simply both sides of the same coin. Indeed, they go hand in hand. They are both reflective of the decline of risk aversion.

In some sense, rising long bond yields are a symptom of an economy that is recovering and a financial crisis that is subsiding. It is a sign that capital markets are back in business.

The same could be said of the decline in the dollar. Despite all of the hype about “monetization” and so forth, much of the decline of the dollar simply has to do with the unwinding of the flight to quality panic. This can be seen in the resumption of flows towards emerging markets. People do not buy Brazilian Reals because they think that it is a more stable currency than the US Dollar in the long term. They buy Reals because in an environment of global growth, they opportunities to make a profit by investing in securities and/or businesses in Brazil. This is an important distinction to make.

Still, rising yields at the long end of the US Treasury curve will have a negative impact on growth if it gets out of hand. Sharply rising yields impacts expectations and has a reflexive effect causing people to wonder: is there a deeper reason why yields are rising?

10 Year yields above 4% is probably the level at which the positive effects of Fed and Treasury stimulus starts to be partially counteracted by the negative effects – particularly the effect on mortgage rates. Note that because of the decline of spreads in the credit markets, mortgage rates have not really gone up nearly as much as one might have thought given the rise in long Treasury rates. However, spreads can only contract so far and 4% is probably the level at which mortgage rates will probably have to rise tick by tick with Treasury yields.

This is an expectations game; not a matter of arithmetic. For example, there is no set quantitative relationship between a given increase in the monetary base and an increase in inflation. This depends on many factors. And expectations are foremost.

In my view, not even the Fed, with its unlimited purchasing power, can prevent long rates from rising if market participants expect that rates will rise further. The Fed and the Treasury must be astute about managing expectations. Recently, there has been too much uncertainty surrounding Fed securities purchase programs and there has been too many delays in the implementation of programs such as the PPIP and TALF. Days like today will remind Geithner and Bernanke that they need to get on top of the expectations game.

Buying Treasuries in a tepid fashion is not a good way to manage expectations. For example, if Treasuries are going to be bought, they should be bought aggressively with a view to crush shorts. This sort of expectation will dissuade shorts to begin with.

With respect to expectations about inflation, the Fed will need to address the issue directly and explain why inflationary risks are minimal. There are plenty of solid arguments to support this view and they need to actively get out in front of this issue.

And somebody should go over and have a confidential talk with some high level Chinese officials and let them know that if import-substituting trade restrictions (tariff or non-tariff) are erected in the US, the US Treasury will not be needing the patronage of the Chinese for purchasing US Treasuries, nor will the Chinese have the money to do so (or to be able to threat that they will refrain from doing so). Every dollar that does not flow out through the current account has the same effect as Fed monetary stimulus and will directly and indirectly become available in the financial system for purchase of US treasuries, in particular by institutions that will capture the savings generated though the current account. Somebody needs to let the Chinese know that further jawboning on the US Dollar at this sensitive juncture may come with a steep price.

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