PRINTMarket Update -- In the Markets
June 26, 2007
Back in April and May, a lot of money managers were buying Treasuries, betting on a slowdown in consumption and an eventual Fed rate cut. Their rationale made sense: consumers, feeling the pinch from rising gas and food prices, would reduce their discretionary spending. Continued weakness in the housing markets, which directly affects everything from mortgage brokers to furniture and appliance manufacturers, would further weigh on economic growth. Recent declines in core inflation gauges reinforced the notion that interest rates were bound to move lower before they moved higher, and as Treasury yields rose throughout the month of May, even more investors got long. Position indicators, such as the weekly JP Morgan Treasury Investor Sentiment index and the Stone & McCarthy Research U.S. Portfolio Manager Survey showed money managers were the longest they had been in years.
But then stronger growth in Asia and Europe fueled concerns about rising inflation. The European Central Bank and the Bank of England were tightening monetary policy in Europe while China continued to fight its own battles against asset inflation. Ten-year German Bund yields rose more than 50 basis points from late March to the end of May as economic data across the region came in stronger than expected. The selling spilled over into the U.S. bond markets just as economic indicators showed a larger than expected rebound in manufacturing activity. Economists pointed toward a replenishing of inventories that had been depleted during the first quarter and many companies began to report increases in exports as well.
Soon the legions of investors who were long duration saw their positions decline in value. Treasury yields broke through some important technical levels, prompting chartists to call for a long-term secular bear market. With their portfolios underperforming benchmarks, many of these portfolio managers chose to cut their losses and trim their holdings back to neutral. The capitulation exacerbated the move in rates and led to even more selling by various mortgage-related investors seeking to shed the excess duration building up in their portfolios due to slowing mortgage prepayments.
On June 7, 10-year Treasury yields rose by almost 17 basis points, one of the largest one-day declines in Treasury prices in years. Less than a week later, on June 12, Treasury yields again rose sharply, rising some 14 basis points on the 10-year to hit a five-year high of 5.30%. Fed funds futures priced out any possibility of a Fed ease as several Wall Street economists who had previously predicted rate cuts abandoned their forecasts and others began talking about the potential for further Fed rate hikes. A number of economists also warned that recent declines in core inflation would prove temporary, and that as long as the economy remained on solid footing, inflation would be poised to reaccelerate in the third or fourth quarter.
Meanwhile, overseas demand for U.S. Treasuries was conspicuously absent. Foreign central banks, which have been a steady source of demand for U.S. Treasury debt, didn't step in to buy large blocks of bonds as yields rose. The unusual lack of overseas interest led to ruminations about a possible unwinding of the "conundrum," a reference to the utterance by former Fed chairman Alan Greenspan in early 2005 describing the unusually low level of long-term interest rates. The global savings glut, to which the persistently low interest rates have been attributed, was caused by a combination of factors including foreign central bank reserve accumulation, European and Asian pension fund demand, and the reinvestment of Russian and Middle Eastern petro-dollars. More recently, however, amid rising yields in competing economies, some portions of that savings-glut appear to be seeking greener pastures abroad.
If we are indeed witnessing the beginning of a broader secular trend out of U.S. assets, the impact on bond prices and other financial instruments could be quite significant. The prospects of this actually occurring have some observers forecasting prolonged bear markets in just about everything from Treasury debt to credit spreads to stocks and even commercial real estate.
Concerns are also mounting about an unwinding of the high degree of leverage that has built up in the structured products markets over the last few years. It's a topic we wrote about in detail in Dwight's First Quarter Economic and Bond Market Update (see "The New Face of Leverage in the Financial System"). As we described it then, leveraged investors buying levered bonds backed by different levered bonds backed by levered assets leaves a razor-thin margin for error. It seems that the sharp slowdown in housing and the dismal performance of recently issued subprime mortgages may be exceeding that margin for error, forcing at least one large hedge fund to desperately liquidate assets and seek forbearance from its creditors. As a result of its holdings being liquidated and the likelihood that similar funds will follow suit, many observers fear that Wall Street firms will quickly rein in their risk exposure.
A retrenchment on the street would limit the availability of credit to hedge funds and funding lines to new CDOs, both of which have been steady sources of demand for risk assets in the fixed income markets. We've already seen this occur to an extent in the CDO market, and as home lenders feel the pinch of softening demand for their loans in the securitized products markets, they are raising their lending standards and writing fewer loans. This tightening of credit is causing further pain for subprime borrowers who need to refinance their mortgages.
Spread widening in structured products markets is impacting other sectors of the bond markets as well. Corporate and high-yield bond spreads have widened, increasing the cost of funding to corporate borrowers. This weakness in the credit markets points to continued underperformance by levered credit investment vehicles, which could, in turn, lead to more redemptions from investors and additional margin calls from lenders.
A gradual and orderly unwinding of excess leverage in the financial markets would be a healthy adjustment for the financial markets, and investors would ultimately benefit from a return to more rational risk-based pricing. There is, however, an acute risk that the pullback will lead to panic and beget massive forced liquidations, which could inflict significant damage to the markets. Under such a scenario, Treasury markets would witness a flight to quality similar to that seen in 1998.
But global investment flows and distress in the subprime and CDO markets haven't really changed the facts on the ground in the U.S. economy. The very concerns that prompted so many investors to bet on falling interest rates back in April and May remain as real today as they did two months ago. The housing market continues to weaken and stubbornly high food and gas prices remain a drag on consumers' discretionary spending power. The only thing that has materially changed for consumers in the past two months is that those who were hoping to refinance out of their adjustable-rate mortgages are now facing higher fixed mortgage rates. It seems to follow that any additional increases in long-term interest rates will further aggravate the situation for leveraged consumers, putting the U.S. economy at even greater risk of a slowdown.
Investors who liked 10-year Treasuries at 4.75% should love them at 5.25%. However, one has to respect the apparent decline in demand from major foreign investors, which makes a 4.50% 10-year look pretty unlikely right now. Taking all these factors into account, we see Treasury yields settling into a trading range in the intermediate-term. Continued risks of economic weakness and the potential for flight-to-quality buying should keep interest rates from rising beyond their recent highs, while the overall demand picture suggests that buying interest won't be deep enough to push rates significantly lower.
We have held a neutral duration position throughout the past few months and are likely to maintain that position in the near-term. We also remain cautious on credit spreads and continue to avoid all lower-rated bonds backed by subprime consumer credit as well as all CDOs backed by structured product. We feel that a bias toward higher quality, liquid spread product will continue to serve our clients well as the markets grapple with the ongoing unwinding of risk-positions in the structured credit markets.
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