Thursday 20 January 2011

Dumb and Dumber - QE2 and the risks linked to global rising Yields in 2011

The discussion around the debt ceiling could trigger a sell-off as high as 100bps in US Treasuries, like in 1996. You want to track the TBT ETF in 2011 as a caution (please see below).

Zerohedge goes into the detail of what could happen if we have a 1996 replay in relation to the debt ceiling discussions.
"It is difficult to disentangle the full effect of the 1995-96 debt-ceiling crisis on bond yields since Fed expectations were also changing rapidly during that time. If there is any conclusion to be made, it is the market generally shrugged off the government shutdowns and instead focused on macro developments.

The government reached the debt ceiling in November, and Treasuries generally rallied over the next three months even as the situation in Washington continued to deteriorate. That said, the Fed was also easing monetary policy during this period, having lowered rates by 50bp to 5.25% between December 1995 and January 1996. Nonetheless, reviewing press reports from this period suggests that the market seemed to ignore the debate over the debt ceiling in the early stages, having assumed that politicians would never allow the US to go into default and that a resolution would be brought about quickly. The biggest move occurred in the final days of 1995 when the market was generally optimistic that a resolution would be achieved.

At the start of the New Year, the market realized that negotiations were falling apart with Treasury Secretary Rubin warning sending the 10-year yield 8bp higher. Around mid-February markets began to react negatively to any news related to the budget stand-off; that is until late March when the ceiling was lifted. Treasury yields increased about 80bps in less than a month during this period."

Marc Faber on 2011 Barron’s Roundtable: Why Everyone Will Be a Billionaire Soon:
Marc Faber and Bill Gross from Pimco had an interesting conversation relating to the state of the US economy and the risks.

Here what Bill Gross had to say:
"I don’t know if the U.S. has reached a desperate point, but it is employing instruments and vehicles and policies that smack of desperation. We are not looking at a default here, but at years of accelerating inflation, which basically robs investors and labor of their real wages and earnings. We are looking at a currency that almost certainly will depreciate relative to other, stronger currencies in developing countries that have lower levels of debt and higher growth potential. And, on the short end of the yield curve, we are looking at creditors receiving negative real interest rates for a long, long time. That, in effect, is a default. Ultimately creditors and investors are at the behest of a central bank and policymakers that will rob them of their money."

This a point Felix Zulauf made:

"There are two worlds—the industrialized world and the emerging world. The industrialized world continues to live in a fiction: that it can afford its current lifestyle by going further and further into debt. At some point, the bond markets will riot against that."

For the entire Barrons January 2011 Roundtable:

Given current risks on a sell-off on US treasuries, it is important to track the following ETF as mentioned previously, namely the TBT: ProShares UltraShort 20+ Year Trea (ETF) (Public, NYSE:TBT):

ProShares UltraShort Lehman 20+ Year Treasury, seeks daily investment results that correspond to twice (200%) the inverse (opposite) of the daily performance of the Barclays Capital 20+ Year U.S. Treasury Bond Index (the Index).

TBT is already up 9.49% in 3 months and 16.63% in just 3 months. Year to date so far: 5.64% up.

That's the result of a rise in inflation expectations in my book...

Rising global yields is a key issue for 2011.

The excellent Doug Noland in his latest Credit Market Bulletin share the same views:

"The possibility for a surprising jump in Treasury bond yields is a major 2011 issue. On the one hand, Treasury is not interest-rate sensitive; the marketplace doesn't have to fear much of an issuance impact from a moderate rise in borrowing costs. On the other hand, this dynamic would imply that yields are poised to surprise on the upside when the markets eventually force borrowing restraint. It doesn't take a wild imagination to envisage a market problem leading to an economic problem, to additional "TARP" (the Trooubled Asset Relief Program bailout) more rescues and a jump in borrowing costs - all combining for a dramatic deterioration in our nation's debt position.

That borrowing restraint is being imposed upon US municipal finance is a major 2011 issue. The year has commenced with municipal bond yields adding to Q4's surprising jump. Today, state and local finance is our credit system's weak link."

Doug goes on:

"Here in the US, policymaking has turned simple: run massive deficits, keep rates at zero, and have the Fed monetize debt until the private sector can be trusted to do the heavy lifting. Well, don't hold your breath. So, for Issues 2011, we can assume the Fed stands pat on rates. And while they have little credibility, both congress and the Fed are talking tough against bailing out troubled states across the country. Whether they can stick to this rhetoric is an Issue 2011. The dollar continues to benefit from the capacity of policymakers to inflate credit, a dynamic that will compound our dilemma when the markets turn their sights on disciplining Washington.

I'll posit that each year of massive government marketable debt issuance reduces the likelihood that central bankers will be able to exit their market liquidity backstop operations. History has shown how systems become precariously addicted to inflationary measures and market interventions. The Fed's balance sheet will only move in one direction. And when push comes to shove, they may be forced to buy municipal debt or monetize more Treasuries to help finance bailouts.

For now, the most important issue of 2011 is that serious structural deficiencies ensure that the Federal Reserve errs on the side of liquidity creation. This would seem to ensure a year of even greater monetary disorder, with the risk of heightened instability throughout global fixed-income, currency, commodities and equities markets."

Dumb and Dumber...

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