Posted on 09/23/2008 10:21:12 PM PDT by bruinbirdman
The clean-up bill for the damaged US financial system has landed with a thud in the government bond market.
There has been a big jump in yields on US government debt since news of the plan to remove $700bn of toxic assets from the balance sheets of US bank first emerged.
After falling to a low of 3.24 per cent last Wednesday – the day when panic about global credit markets was at its height – the yield on the 10-year Treasury note had climbed back to 3.90 per cent early on Monday. On Tuesday, the 10-year benchmark was yielding 3.84 per cent.
Meanwhile, the yield on the two-year note was at 2.11 per cent, well above last week’s closing low of 1.64 per cent. This suggests that, for the moment, safe-haven buying and investor worries over economic slowdown – which normally drive yields lower – is being eclipsed by concerns over the prospects for increased issuance.
William O’Donnell, strategist at UBS, says the Treasury market “does not know which way to turn as unemployment rises, home prices fall and the tab at the Treasury rises apace.”
A weak economy will limit the rise in yields, but the Treasury market can no longer ignore the fact that the budget deficit could hit $1000bn in the fiscal year beginning in October, double previous estimates.
“One has to acknowledge that this is a sea change and it bearish for the Treasury market,” said David Ader, bond strategist at RBS Greenwich Capital. “The fact of the matter is that while the government says it will cost $700bn, the market wonders whether the ultimate bill will be much higher.”
Bond traders are also totting up the cost of all the other bail-out measures announced this year.
These include a proposed $500bn boost for the Federal Deposit Insurance Corporation, which has been strained by guaranteeing bank deposits at failed institutions this year and the original $200bn cost of back-stopping Fannie Mae and Freddie Mac among other needs.
Jamie Jackson, portfolio manager at RiverSource Investments said: “A weak economy will also reduce tax receipts and add to the fiscal burden.”
Economists at Merrill Lynch expect the budget deficit for 2009 will reach $900bn and $825bn in 2010. However, for Treasury, it is not just about new debt.
Coupled with the growing bill is the amount of existing debt that will be refinanced in the coming years. Merrill estimates that the total funding need for the Treasury will be close to $1,500bn for the next two fiscal years.
Traders expect plenty of changes in the schedule and size of Treasury auctions as the red ink gushes.
Treasury will sell a record $34bn of two-year notes today and $24bn five-year notes on Thursday, the largest amount since February 2003. Both auction sizes are $2bn higher than in August.
Ted Wieseman, economist at Morgan Stanley, says that if those auction sizes are maintained for fiscal 2009, it would raise a further $48bn, “which clearly isn’t much compared to the size of the potential funding gap.”
In order to help plug the gap, traders expect the return of the three-year note and possibly the old seven-year issue, along with more auctions of 10-, and 30-year debt.
A preference for selling long term debt makes sense as long-dated bond yields are historically low, particularly when compared to the current core inflation rate of 2.5 per cent for the year to August.
Low long term yields may not suffice for much longer. Renewed falls in the dollar are inflationary and foreign investors could reduce their hefty holdings of government debt.
Mr Jackson said: “Lax fiscal policy and a weak economy is not supportive of the currency and that adds to the inflation problem.”
With Treasury seeking to swap impaired private sector assets held by banks for public debt, there is a debate about how foreign investors - who hold $2,676bn, or 56 per cent, of the $4,800bn in Treasury debt - will react.
Wrightson Icap argues that removing tainted assets and replacing them with Treasuries is a shift in the composition that “makes the universe of US debt instruments more attractive to foreign investors on balance, and, if anything, will encourage larger capital inflows and greater dollar strength.”
Dominic Konstam, head of interest rate strategy at Credit Suisse, takes a different view. He says: “Increased supply should be associated with higher yields, particularly as the marginal foreign buyer is showing signs of no longer buying Treasuries.”
He adds: “There is a need for higher rates in order to encourage new domestic buyers as foreign investors back away.”
That scenario will maintain the pressure on long dated yields, which will adversely affect home loan rates at time when policymakers are desperately hoping that the housing market will soon stabilise.
On the other hand, the US banking sector stands to benefit. A steep yield curve, whereby long dated yields rise much faster than those for Treasury bills, will help banks repair their balance sheets. By increasing the difference between short and long dated Treasuries, banks can earn much higher returns over time. This would repeat the healing process that was seen in the early 1990s when the curve was very steep.
Another possible silver lining is the ongoing consolidation among the ranks of Wall Street dealers ahead of a huge run-up in Treasury debt sales.
Tom di Galoma, head of Treasury trading at Jefferies, says: “It is a healthy scenario and I think plenty of money is going to be made by the dealers left in the government bond market.”
I changed a couple of years ago to a 100% stock fund. With the safe-havens falling does this really hurt in the long run? I’m down 16.49 for the year.
yitbos
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