Price of Oranges in the USSR and Treasuries in the US
What was the price of oranges in the USSR? Whatever Stalin said.
What is the price of treasuries in the US? Whatever Bernanke says.
By and large we all accept that nothing in the Soviet Union was natural. It was all manipulated by the powers that be, to create the illusion they wanted. Yet somehow, we cling to the illusion that treasury prices, or yields, tell us something useful.
The Risk of Using Treasury Prices to Interpret Anything
We continue to accept the idea that treasury prices are low because we benefit from a flight to quality. We want to believe the shape of the curve tells us something about inflation expectations. It always has, but does it still?
The November 2021 treasury bond, so the 10 year bond issued last November, is 33.47% owned by the Federal Reserve. Over a third of the bond is held by them, and they didn’t participate directly in the new issue, so they have accumulated that much. The Fed owns $23 billion of a $70 billion issue, yet somehow we pretend that they aren’t the driving force behind the price?
On any given day, the price move will reflect some element of risk on/risk off, safety, and even inflation concerns, but we have to be very careful that we aren’t measuring from an incorrect baseline.
Investors have to make very specific regulatory filings when they hit benchmarks like 5% and 10% in equities. This is because the regulators have decided that represents a “controlling” stake and has the potential to influence prices. But 33% ownership across the board in long dated treasuries is still a “market price”? Yes, some more recent issues haven’t achieved that high level of ownership, but some older high coupon bonds are at the 70% Fed limit.
So as we sit here, looking at treasuries, trying to figure out what QE3 means, we are looking at the wrong place. For every policy “wonk” who talks about how current debt levels haven’t affected demand for treasuries, well they are probably wrong. For everyone who says inflation expectations remain low, they may be wrong too, because of the Fed purchases. Don’t forget the Fed dabbles in TIIPS as well.
And it isn’t just the outright ownership that matters and impacts prices. The Fed continues to buy, keeping demand high, but since they are so open about it, every money manager in the world knows there is still a deep pocketed investor determined to buy treasuries, so why fight it too hard?
The Problem Won’t Come From Treasury Yields
I have grown more convinced that the first real problem that comes out of Fed policy will not be a spike in yields. We may get some hints of problems below the surface in the treasury market, but it will just be ripples of a problem about to appear elsewhere.
The Fed can and will suppress interest rates. They will buy treasuries. We can see weakness there, but we won’t see a full out collapse because no matter what happens the Fed will buy.
I’m not expecting a collapse in treasury prices, but I don’t think, in a normal world, we would have yields anywhere close to where they are now. The world no longer perceives a treasury investment as safely as we do.
We are living in an illusion that the Fed is happy to perpetuate, and much like the lucky Soviets who got oranges, we are happy to go along with it.
We need to be looking at other markets, currencies and commodities in particular. The image I get is of a big fat Fed sitting on a water balloon trying to suppress rates. Rates rise, no matter how much water is pumped into that balloon, because of the fat man sitting on it, but it eventually, if nothing changes, it will explode and will create a mess, one that we haven’t seen before and are not prepared to deal with.
So while I hope that the economies turn around without much more intervention, I spend less and less time looking at treasuries as a good barometer of anything. Short term changes may be indicative of investor sentiment, but the overall level is too manipulated to be a strong indicator of anything.
Investment Grade CDS Roll Day
It is early on the semi-annual CDX index roll day, but there are some hints that there might be pent up demand for credit protection buyers.
This is shaping up as the sort of market where investors looking to put on shorts didn’t buy IG18 with the intention of rolling, they decided to hold off until IG19 came out. Post Fed, why short for a week and pay for both the roll down the curve and the bid/offer to move into the new index? That is particularly true in what has been an incredibly low volume and low volatility world.
With virtually everyone long cash, and the market failing to provide any real strength post the initial 22 hour QE rally, we should see some hedges come on.
This is another leg to why I believe we can see a pullback. While I still think CDS will go tighter by year end, now is the time to expect some weakness in this market.
Spain’s “successful” bond auction today may encourage Rajoy to negotiate for even better terms, a mistake, but one he seems intent on committing.