Debt Distribution

The 10 yr bond has given some of us some anxiety over the past few days/weeks.  Admittedly a rally from low 2% to high 3% is big (at least on a change basis…debatable on a level basis, although it would be a high real yield if we descend into a deflation depression what that’s not the baseline expectation at this point).  All this being said what is causing the large fall in U.S. debt (remember a rising yield mean a falling bond price)?  The answer as far as I can tell is awkward auctions.  Where the price for new issuance is not coming in where the market expects them and it is shaking the confidence of debt buyers.  Some people have speculated that China has taken a breather from buying treasury debt to show that they don’t have to do so.  If that is the case, which doesn’t show up on a level basis in the custodial holdings (it could be done via a shift in maturity structure purchasing), and they want to keep their currency policy they have to buy other $ assets.  If they are unhappy with the risk of US treasury bonds its hard to imagine they are happier with – say – equities or corporate bonds.  That being said that could have rock the asset class or debt distribution boat for a few auctions to send a message. 

What would that message be?  In part ‘we want assurance about better fiscal policy/we want to be paid back’  but it is also about the type of debt that is being offered.  The U.S. treasury department has been issuing a lot more 3-5 yr issues instead of bills while bills have appeal to these hyper-risk adverse policy investors.  They are not being given the flavor that they want, thus the boat is rocked.  From the U.S. perspective you can push the 3/5 year debt and risk bumps but you have less roll over risk over the next few years.  I think this is a smart strategy (I’m assuming this is being done explicitly). 

This reality is illustrated in the following chart which show three snap shots of the Federal Debt Distribution (the portion that I’m talking about is the difference between Feb-09 and May-09…2000 is there for other reason). 

Brady’s Gift to The Emerging World

Many of us are familiar with the Brady Plan.  The idea was to convert loans owed by Latin American countries to major banks into bonds.  This would removed those loans from the banks book and start facilitating a working out process.  (Yes another banking crisis).  Well I was working around with debt issuance data and noticed that if you look at the outstanding bond debt of the emerging world it looks like the Brady plan not only help provide a means to work out the banks debt but also brought the developing world forward in terms of their access to markets, in that the amount of subsequent debt they were able to issue was larger than one would have excepted given the previous growth trend.  This makes sense to a degree in that once you have a certain amount of bonds you will achieved initial velocity…meaning their is likely someone is analysing it, likely a two way market for the debt and the infrastructure is there to facility the demand, so you – as a creditor – are now enabled to borrow more.  Another possible reason would be that the issues were big enough to deploy meaningful amounts of capital and thus attracted institutional investors.  Another plausible explanation would be that the Brady debt allowed developing countries to prove their creditability and thus gain acceptance to the bond markets.  This seems to jive with the fact that debt didn’t grow much during 91/92 (although it was positive) after the Brady jump in ‘90 (they worked off the old crisis), but then grows rapidly after ‘93. 

Let me explain the chart.  The blue line is the actual level of outstanding developing market debt; the red line is the level of debt before the Brady plan year grown by the historical growth rate (it eventually passes the blue line but that is not the point, of course growth will slow as the level gets higher…); the point is that the developing bond market got a jump start from the Brady issuance and thus became a market much faster than it would have otherwise.  If we say that 200 billion is the measure of a true market then it got their in ~94 but wouldn’t have gotten their until ~99 without Brady. 

Is this good or bad?  This is a cursory observations and not a vigorous analysis so who knows but it raises some interesting questions.  It seems good in the sense that capital could be deployed and that credit became more liquid but where these countries ready for capital markets (yes they were having petrol dollar sent their way via the banks before this) but did they have the financial system infrastructure to handle more capital inflows?  Did these markets encourage greater economic problems down the road?  Likely a mix of both and – depending on the country – I suspect a different answer would emerge but I think it is interesting to see how the Brady plan jump started the developing world debt markets.

Ten Years of Uncertainty

Today’s FOMC releasediscussed the Fed’s decision to continue the quantitative and qualitative easing programs which have allowed the Fed to play the role of the banking system-performing credit and maturity transformations-while ensuring that the money supply doesn’t collapse.  The release also mentioned that the Committee was “evaluating the potential benefits of purchasing longer-term Treasury securities.”  That may have triggered the large rally in treasuries that pushed the 10-year yield down to 2.27% (down 25 bps). With this in mind, I’d like to expand on yesterday’s post.

First, consider that an arbitrage relationship exists between a 10-year rate and 40 sequential 3-month rates.  You could finance the purchase of a 10-year bond with funding from the next 40 3-month rates.  Next, imagine that market expectations are that the 3-month rate will be 25 bps (the high end of the new fed funds target range) over the next 10 years.  If the market were certain, then the ten-year rate would be 25 bps as well, but the situation changes when those expectations are uncertain.  Let’s say that market expectations are normally distributed with annual volatility of N (a stylized assumption to illustrate a point).  As the range of plausible 3-mth rates expands, the bottom of the distribution is cut off by a certainty, the zero nominal rate.  The market 10-year rate ends up being a value based on the weighted average of the expected rates. The truncated distribution thus moves the expected rate away from the first guess (25bps).  This can be thought of just like an option (selling the bond has limited downside in a nominal sense).

You can now see how uncertainty affects rates.  How much does this upward pressure on rates matter? The soft floor on the 10-year rate will be a function of the uncertainty about the future path of the 3-mth rate, as illustrated by the following chart.  The open question is what you think the proper degree of uncertainty is for the 3-mth rates.

 

Update: It is worth nothing that Japanese 10-yr rates fell below 1% (although they’re usually in the high 1% range).  One plausible explanation for this is that in a deflationary environment (inflation is running at -5%) where the nominal short rate is 0% but in real terms it is higher at 5%, it is hard to imagine the monetary authority actually wanting a tight monetary policy.  This may give you a large degree of confidence that the nominal rate will not increase, meaning that the distribution contracts and thus the 10-year rate is able to fall.

Federal Reserve Challenge: When normal just doesn’t cut it.

When the economy slows, the first responder is the Federal Reserve. It eases monetary policy by lowering the bank reserve rates (it is often tight monetary policy which triggers the slowdown in the first place).  This time around, the Federal Reserve responded more aggressively than usual, but they quickly realized that in this cycle problems would not be solved by decreasing the interest rate paid on loaned reserves.  As the reserve rate was cut, the rates that were paid by consumers and businesses did not drop-in some cases they even increased because spreads increased faster than rates fell.  The Fed’s efforts were ineffective.  Now the rate is approaching the 0% nominal floor, which means that this type of intervention (in a nominal sense) is about to run out of bullets. 

 But the Fed did not settle for the standard policy tools; it has gone well beyond what is normally done to stimulate the economy.  One means to stimulate credit is to guarantee bankers access to liquidity, so bankers need not worry about liquidity risk when doing maturity transformations (borrowing short and lending long).  With this in mind, and a focus on preventing widespread banking failures, the Fed started to push out liquidity to banks through programs such as the Term Auction Credit program (after discovering that no one would use the discount window).  This program was useful in that it held the system together (we would be a lot worse off without it), but for the past few months the Fed hasn’t been able to push money out the door. This means that for every 100 dollars it auctions, only a fraction, say 60 dollars, is bid on.  Banks are so focused on deleveraging that they have no interest in doing maturity transformations even with cheap Fed money. 

 As things continued to fall apart, certain markets, such as commercial paper, were on the verge of collapse. The Fed’s response was to set up a program to provide liquidity so that bankers could buy the CP, but it quickly realized that it wouldn’t work because bankers were not interested in expanding their balance sheets.  The Fed then set up a program to take the CP on its own balance sheet.  We have now reached the stage where the Fed has taken on the maturity and credit transformation responsibilities which were once the role of the banking system.  Examples of this include the money market investor facility, the commercial paper facilities, and the new GSE purchase facility (and possibly a program to buy long term government debt).  In addition, the Fed has held together the fragile banking system by facilitating the JPM-Bear Stearns deal and providing ‘liquidity’ to AIG. 

 Now that I’ve gone over what the Fed has done so far (and how unconventional its actions have been), a fair question would be ‘what else could the Fed possibly do during its meeting on Dec 15/16?’  It could expand the existing programs and commit to buying more risky assets (thereby committing to do more maturity and credit transformation).  Even though this seems like more of the same, it would be beneficial.  I think the Fed should also provide transparency to the market on the duration of these programs.  While this would require the Fed to keep these programs in place or interest rates low for a certain period of time, which bears some risk, it would also allow the market to start pricing in the continuation of these programs and possibly encourage bankers to take advantage of the subsidies provided.

 To show the effect that future assurances could have, look at the forward interest rate picture.  The most likely path as imputed from Fed Futures (financial instruments used to transact on future rates) is that rates will fall to 25 bps (0.25%) and stay there throughout 2009.  But the futures curve for the same interest rates has them priced at around 80bps (0.80%) at the end of next year.  Why the difference?  Because as time increases, so does the uncertainty surrounding the expected rate.  If you look at the -1 SD (standard deviation) and +1 SD line, you’ll see a plausible distribution for future rates.  Think about it this way as the prediction is about a further point in the future you become increasingly uncertain about the prediction.  The expected rate ends up being the average of this distribution of rates. The problem is that the low side is truncated at zero so even if one does not expect rates to increase, the fact that your uncertainty increases as the duration of your prediction increases means that the forward curve prices in higher rates.  If the promise were made to hold down the rate at 25bps through 2009, then the forward curve would drop because the +1 SD deviations would drop (based on our confidence in the Fed’s statement).

 

Remember flatting out the short rate curve will pull down long rates.