Top-10 Reasons for Latest Sell-Off in Treasuries
At 4.57%, the yield on the 10-year Treasury note is at its highest
since the end of March and is nearing its 2005 closing high yield of
4.64% set on March 22nd. There are many reasons for this latest
sell-off, some of which make the sell-off appear sustainable. This is
in contrast to past sell-offs when yields above 4.50% for the 10-year
were short-lived. In fact, as I have been suggesting since July, it is
looking increasingly likely that the 10-year's trading range is
re-setting from the placid 4.00% to 4.50% range that has prevailed for
2 1/2years to something higher; 4.25% to 4.75% for now, and possibly
higher later, if the market begins to price itself for a fed-funds rate
of 4.75% or higher.
The root-cause of the sell-off in Treasuries relates to the risks posed
by the possibility of a 4.50% fed-funds rate. A week ago, by the way,
the market was priced for a roughly 50% chance that the fed-funds rate
would be raised to 4.50% at the January 31st FOMC meeting. Now,
however, the market is placing odds at closer to 80%. This is
important because the funds rate essentially represents the floor on
yields for Treasuries with maturities of greater than two years. Why?
Because investors are loathe to invest in Treasuries when they yield
less than the fed-funds rate, primarily because the fed-funds rate
represents the cost of money to those who borrow money in the repo
market to finance their inventories of Treasuries.
It is rare for coupon Treasuries (issues dated 2-year and longer) to
yield lower than that of the federal-funds rate. In fact, for the
2-year T-note there have been only five occasions in sixteen years
wherein its yield dipped below the federal-funds rate. On each
occasion the Federal Reserve lowered interest rates within six months,
with most rate cuts occurring much sooner than that. Investors thus
tolerated this so-called negative carry for short periods solely
because they felt the Fed would soon lower the federal-funds rate, thus
reducing borrowing costs and restoring positive carry to their
investments.
Here are nine other reasons for the weakness in Treasuries:
1. European bonds are trading very poorly. In Germany, Italy,
Spain, and the U.K., for example, yields have increased around 14 basis
points in two days on the 10-year notes in each of the respective
countries. One source of weakness was yesterday's German IFO survey, a
survey of business confidence. It unexpectedly reached a 5-year high.
Another source of weakness was inflation data in Germany, which saw
greater-than-expected increases. More hawkish commentary from
officials at the European Central Bank have also played a major role.
2. Strength in European economic news spurred a 1% decline in the
dollar on Tuesday, which is likely weighing upon Treasuries, along with
a sharp rally in gold.
3. An added reason for selling of dollar assets is the possibility
of indictments of top officials within the Bush administration.
4. In Germany, one its top-five mortgage lenders, AHBR, is said to
be having difficulty, according to the Financial Times, which says that
the company is "close to failure." If it fails it would be Germany's
largest bank failure in 30 years. The worry in global bond markets is
that in the event of a liquidation the bank would sell large amounts of
fixed-income securities.
5. Hedge funds have been seen selling U.S. 5- and 10-year notes in
large size. Commodity trading advisors have been prominent in the
futures markets.
6. There has been heavy selling of mortgage-securities, which is
the biggest segment of the bond market and which thus exerts enormous
influence over the market. As interest rates rise, the average
duration (or maturity) of mortgages rises because both home sales and
mortgage refinancing slows. This leaves the holder of mortgage-backed
securities with more securities than expected (because a certain
percentage of these securities were previously expected to be pre-paid
upon either a home sale or a refinancing), forcing the holder to either
sell mortgage securities or Treasuries to hedge against a further rise
in interest rates.
Here's a quick example. Suppose a mortgage-securities investor held $1
million in mortgage-backed securities and expected that 30% of these,
or $300k would be prepaid over the upcoming year owing to home sales
(which close out existing mortgages) and refinancing activity. Suppose
again that rising mortgage rates were to result in reduced home sales
and mortgage refinancing activity and hence, only a 10% prepayment
rate.
This would leave the investor with $200k more securities than expected
and thus perhaps more than is desirable. In this situation the
investor can either sell $200k of mortgage securities or $200k of
Treasuries to reduce his or her exposure to changes in interest rates.
The investor could sell additional securities if he or she wants to
guard against a further rise in interest rates.
7. The results of Tuesday's 5-year TIPS auction were poor, as
measured by a low bid-to-cover ratio, higher-than-expected yield, and
low numbers of indirect bids (end-user demand). The poor results have
left the Street with distribution problems that are complicated today
by the auction of $20 billion of 2-year T-notes.
8. Treasuries have been trending down but took a respite following
deeply oversold conditions a week ago (RSIs reached 19.0). The
sell-off is resuming and will likely continue if the threat of a 4.5%
fed-funds rate becomes even more widely anticipated.
9. The Bernanke appointment clears a major uncertainty but many
uncertainties remain including the makeup of future policy statements
(Greenspan writes the current ones); the ability to form a consensus
despite wide disagreements (30% of FOMC meetings had disagreements with
Greenspan view but only 7% with official dissents); flexibility, a
hallmark of Greenspan's; public speaking abilities (Bernanke's are good
but not as strong); the need to relate to Wall Street and Main Street
and avoid the trappings of academia; and the risk of a new
inflation-targeting regime, which could well be adapted if President
Bush selects two inflation-targeting proponents to fill the two vacant
seats on the Board of Governors of the FOMC (there are seven governors,
including the Fed Chair). Moreover, Bernanke could well look to assert
his inflation-fighting credibility early on, which makes it more likely
that he might lean on the side of tightening credit, at least in the
early going.
