<blockquote>
'The Eurozone and the UK now recognize the necessity for a more “austere” approach to government debt growth. The U.S. has not – and likely won’t until the market forces its hand. So there is now a clear policy divide for the markets to contemplate. In Europe, there appears a willingness to accept some short-term pain for the good of long-term stability...
The markets are still sorting out new post-Greek crisis realities. For some time, the markets have gladly sided with the inflationists. Are the vigilantes quietly coming out of hiding? I would expect the markets to increasingly appreciate that the Europeans are moving in the right direction...
Prior to Greece, the markets perceived rapid government debt growth was a stabilizing force. More recently, the marketplace is coming to grips with the reality that runaway fiscal deficits are destabilizing and problematic...'</blockquote>
Bond Bubble?By Doug Noland
June 25, 2010
Source“I find it truly amazing to see how many pundits refer to the bond market as if it is in some sort of a bubble. How can a security whose price is constantly projected to decline by the economics community be in a bubble? How can any asset class be in a bubble where the capital is guaranteed and which pays out a coupon twice a year? It makes no sense.” David Rosenberg, chief economist and strategist at Gluskin Sheff & Associates, writing in the Financial Times, June 21, 2010
As an analyst of Bubbles, the economic community’s price sentiment is not high on my list of key Bubble indicators. And it is the nature of Bubbles to flourish specifically because of perceptions of seemingly guaranteed returns (tech stocks only go up, home prices have never gone down, governments don't default, etc.). I have theorized that policymaker response to the 2008 bursting of the Wall Street/mortgage finance Bubble unleashed a Bubble in sovereign debt – the “Global Government Finance Bubble.” I see ongoing evidence supporting this thesis.
Yet there remains a contentious debate on whether Treasury bonds are in a Bubble. The bond bulls – most with strong views anticipating a deflationary backdrop – see Treasury prices well-supported by underlying inflation trends. The best I can tell, the bullish camp doesn’t venture far away from prices when it comes to Bubble analysis. They also tend to view Bubble risk in terms of the probability for imminent major price declines. My Bubble focus is on structural effects, both financial and economic.
I am reminded of the discourse back in the Bubble period 2004-2007. Many, including Federal Reserve Chairman Greenspan, argued forcefully that housing wasn’t in a Bubble. The Bubble apologists were fond of the presumption that “there can’t be a national housing Bubble because real estate markets are always local.” Such shallow commentary ignored the national dynamics of the mortgage Credit marketplace. It also disregarded the speculative dynamics that had come to command both mortgage finance and our real estate markets. And, importantly, the apologists failed to factor in the major structural distortions wrought from trillions of mispriced mortgage Credit.
Bubble analysis must focus first and foremost on the underlying sources, quantity and dynamics of the underlying Credit. Are there unusual supply and/or demand dynamics at work fueling self-reinforcing market distortions? Is over-issuance of Credit fundamental to the market’s perception of minimal asset price risk? Are other dynamics at play providing market participants assurance that risks can be downplayed or even ignored? Bubble analysis should de-emphasize near-term price fluctuations/prospects and instead focus on ongoing structural Credit, market, and economic effects/impairments.
The major rally in Treasurys and the dollar over the past couple of months helped solidify the bullish view that our nation’s fiscal situation is relatively benign and that the U.S. retains its premier safe haven status. An alternative explanation posits that much of the rally has been “technical” - the result of the crowd caught on the wrong side of global leveraged speculations. Moreover, I strongly believe that both Treasurys and the dollar have benefited from the markets’ perception that the U.S. enjoys a competitive advantage in “reflation” – that our policymakers continue to enjoy great flexibility and latitude for both fiscal and monetary stimulus. In stark contrast to Greece, a prevailing bullish view holds that massive ongoing U.S. fiscal and monetary stimulus ensures U.S. assets (debt and equity securities and real estate) retain both an inflationary bias (prices tending to rise) and less downside (Credit dislocation) risk.
Back in November - and in spite of gross borrowing excesses - the markets were fine lending to Greece for two years at about 2%. Two-year Greek yields traded today at 10%, down from as high as 18% last month. Were Greek bonds in a Bubble this past autumn? I would argue an emphatic “yes” and then question why analysts would not contemplate that similar misperceptions and speculative dynamics might be in play in our debt markets.
The markets were convinced that Greek debt was essentially guaranteed by the Eurozone – as well as backstopped more generally by global policy-induced market liquidity excess. As such, underlying fundamentals were not a primary market concern. This fateful market misperception was similar to the mortgage finance Bubble belief that Fannie, Freddie, the Fed and Treasury would ensure uninterrupted liquidity and stability throughout the mortgage, MBS and housing marketplaces.
These are precisely the types of major market distortions that virtually ensure spectacular booms and busts. As long as ample new borrowings – Greek debt or U.S. mortgage Credit – were forthcoming, a semblance of stability and sustainability was maintained. But as soon as market yields rose – and more fundamentally-based risk premiums took hold – the true state of underlying structural debt problems were illuminated and the bubbles soon burst. For an extended period, the market accommodated Bubble excesses, only to see the Bubble falter almost the moment that this accommodation began to wane.
Are Treasury bonds a Bubble? Well, I certainly believe major market misperceptions are deeply ingrained and significantly distorting prices. I see a marketplace where the prospect for ongoing massive issuance is having minimal impact on prices and risk perceptions. I see over-issuance of Treasury debt significantly impacting the pricing and perception of risk throughout our securities and asset markets. The unprecedented expansion on government debt is surely having a major influence on the flow of finance throughout the economy and, over time, having deleterious effects on the underlying financial and economic structures. I see self-reinforcing dynamics where the over-issuance of government Credit foments speculation – in many markets. And I would argue that underlying fundamentals are masked by ongoing Credit excesses and the attendant mispricing of risk. Market underpinnings would deteriorate rapidly with any significant change in market perceptions and a resulting rise in yields.
Market perceptions are in the process of changing. Municipal Credit default swap (CDS) prices jumped again. This week, California CDS prices surged 46 bps to 346 bps. Illinois CDS rose 48 bps to 360 bps. New York State increased 35 bps to 284 bps, and New York City CDS rose 21 bps to 237 bps.
While changing perceptions may not yet be manifesting in higher Treasury yields, it is apparent that the markets are taking a much dimmer view of U.S. debt risks. In particular, muni debt protection costs have risen dramatically, and junk bond spreads have widened about 200 bps over the past six weeks. It is also worth noting that dollar strength has begun to wane. Perhaps subtle, but a case can be made that market concern for structural debt problems is shifting to the U.S. At the early stage of a changing market risk focus, one would expect the marginal borrowers (muni and junk) to begin to suffer (as Treasuries, for now, retain their bulletproof status).
In an op-ed piece in Wednesday’s Financial Times, German Finance Minister Wolfgang Schauble defended Germany’s focus on reining in German and European fiscal deficits:
“To the question of what caused the recent turmoil in the eurozone, there is one simple answer: excessive budget deficits in many European countries. It comes therefore as a surprise, to me at least, that one of the most passionately debated economic issues of the day should be whether Germany is acting prematurely in reining in its deficit and thereby choking the rebound at home and in our neighbours’ markets. My response is an emphatic no.” Later in the article Mr. Schauble wrote, “Behind the calls for us to pursue a more expansionary fiscal course lie two different approaches to economic policymaking on each side of the Atlantic. While US policymakers like to focus on short-term corrective measures, we take the longer view and are, therefore, more preoccupied with the implications of excessive deficits and the dangers of high inflation.”
The Eurozone and the UK now recognize the necessity for a more “austere” approach to government debt growth. The U.S. has not – and likely won’t until the market forces its hand. So there is now a clear policy divide for the markets to contemplate. In Europe, there appears a willingness to accept some short-term pain for the good of long-term stability. Here at home, there remains a stubborn adherence to inflationism.
The markets are still sorting out new post-Greek crisis realities. For some time, the markets have gladly sided with the inflationists. Are the vigilantes quietly coming out of hiding? I would expect the markets to increasingly appreciate that the Europeans are moving in the right direction while we are resisting.
Prior to Greece, the markets perceived rapid government debt growth was a stabilizing force. More recently, the marketplace is coming to grips with the reality that runaway fiscal deficits are destabilizing and problematic. How this appreciation manifests in the markets over the coming weeks and months will be something to watch and analyze. Higher Treasury yields? Do tighter financial conditions throughout the U.S. Credit market stop recovery in its tracks? A weaker dollar? And could renewed dollar weakness – in concert with European stabilization and Asian expansion - help reignite some global reflationary forces? There are at least a few ways Treasurys could disappoint.