Following yields up and down

A quick follow-up on a point I made last week ([1],
[2]) about the factors behind recent interest rate moves.

One view is that the prime cause of recent changes in interest rates has been changes in foreign demand for U.S. assets. If a foreign flight from U.S. Treasuries was responsible for the earlier dramatic rise in the 10-year yield, I would have expected that to be accompanied by downward pressure on the dollar.



Daily value of dollar (left axis, in euros per dollar, from FRED) and yield on nominal U.S. 10-year constant maturity Treasury (right axis, also from FRED).
dollar_10_yr_jun_07.gif >



But the above graph shows pretty clearly that over the last 6 weeks, the correlation has been in the opposite direction. The dollar gained in value while long-term yields were rising up until a week ago, and the dollar and yields fell together since then. That suggests to me that much of the changes in yield we’ve seen may be driven by events inside rather than outside the United States. Specifically, if investors (both U.S. and foreign) came to perceive improved prospects for positive real economic growth over the next 1-2 years, that could account for both a rise in U.S. yields and a rise in the dollar. A new dash of pessimism last week would have brought a correction back down for both.

As for what might have contributed to the latter, I personally did not care for the latest consumer sentiment readings, and continue to worry a good deal about whether declining real estate prices could contribute to some systemic financial difficulties. Tanta had a trenchant summary of the implications of the Bear Stearns developments:

there don’t seem to be nearly enough reported principal losses on actual subprime loans to account for the magnitude of the BS Funds’ losses on a dollar-for-dollar basis, which does kind of suggest to us simpletons that something out there is magnifying, rather than dispersing, all this credit risk.



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16 thoughts on “Following yields up and down

  1. Fat Man

    “there don’t seem to be nearly enough reported principal losses on actual subprime loans to account for the magnitude of the BS Funds’ losses on a dollar-for-dollar basis”
    Do not ignore the ability of “smart” guys on Wall Street to multiply their losses by means of leverage, including not only traditional borrowed money, but also all kinds of fancy derivatives and swaps.

  2. Zar

    For every principal loss on a subprime loan, reflected in the CASH subprime bond, there are multiple $ being exchanged in synthetic positions replicating the subprime borrowers. Unfortunately this is not easily observable and who knows how many CDS, CDOs have been replicated from the California Subprime borrower

  3. sam

    do not forget the impact of CDO^2 and perhaps even CDO^3.
    Morgan Mafia invented it. The house of Morgan is never wrong.

  4. Anarchus

    This description of one of the Bear Stearns hedge funds is actually quite funny:
    ” . . . started in 2004 and had done well, posting 41 months of positive returns of about 1 percent to 1.5 percent a month . . . ”
    The only world in which managers post 41 months of positive results of 1-1.5% is a fantasy world in which the managers themselves are allowed to decide what returns they report.
    The key is to have a lot of assets in your portfolio that have no liquid market whatsoever. That way, the PM may control “the mark” and so gets to dictate his own results for a while.
    This is just a harbinger of an extremely serious problem looming. One reason that credit spreads are at historic lows today is that there’s an historic amount of hedge fund money in fixed income “relative value” strategies. Astonishingly, my sources suggest that the magnitude of assets managed this way is several multiples larger than what was managed this way back in the LCTM era. The steadily growing weight of all this relative value money chasing yield (credit, liquidity, maturity based) has pounded spreads to incredibly low levels. For now.
    The problem is that systemwide hundreds of billions of $$$$$ are highly if not obscenely leveraged to the same general positive carry trade: LONG less liquid, riskier, longer-maturity assets and SHORT more liquid, less risky, shorter-maturity assets. These trades may not appear to be highly correlated 99.9% of the time; however, when credit crunch contagions inevitably strike in a discrete firestorm, the correlations all go to +1 or -1.
    The acid test is going to be when (NOT if) credit spreads someday widen by 100-200 basis points over a relatively short period of time. All the dry tinder and gasoline and black powder needed for a worse-than-1998 epic financial disaster is just sitting there, waiting for a spark.

  5. kharris

    Short-term overshoot is a fairly common occurance in financial markets. Rather than looking to wiggles in second tier data like consumer confidence to explain a pull-back in rates, might we not think that rates overshot during their rise and have now corrected some of the overshoot.
    I do think, though, that you are on the right track in rubbing to markets up against each other to see what is going on. Rather than foreign selling driving rates, fx trade suggests rates are attracting foreign buying. This is, by definition, short-term stuff for now. We don’t know what accounts with a longer-term investment horizon are doing, because we haven’t see data on flow (other than Fed custody holdings) and haven’t seen the dollar and interest rates both up for very long. We know very little, and can usefully speculate only in a very limited way. Short-term price action has a very high noise component.

  6. Anarchus

    Conventional wisdom from the 1970s would be that higher oil prices are inflationary so interest rates go higher.
    The traditional contrary view is that higher oil prices for importers such as the US and China act as an informal tax increase paid to OPEC and non-OPEC exporters and so interest rates go lower.
    The new conventional wisdom is that petrodollars from higher oil prices are immediately recycled into capital market bonds and paper and so in a world already awash in surplus savings higher oil prices put interest rates down.
    To the extent you believe in Peak Oil, I think the most likely outcome would be steadily rising crude prices that rise to the point where economic growth is choked off so that the energy markets can clear. That’d likely provoke a deflationary recession with much lower interest rates . . . . . .
    But with complex multifactor processes like this, the interaction of economic growth, oil prices, recycled petrodollars, monetary policy and interest rates is so iterative that ceteris paribas scenarios aren’t all that useful, IMHO.

  7. DickF

    Anarchus wrote:
    To the extent you believe in Peak Oil, I think the most likely outcome would be steadily rising crude prices that rise to the point where economic growth is choked off so that the energy markets can clear. That’d likely provoke a deflationary recession with much lower interest rates . . . . . .
    Anarchus,
    Does Peak Oil Theory require one to discount innovation in methods of enerty production? Since we have relied on oil as a primary source for around 100 years, does that mean that oil will be the primary source of energy in perpetuity?

  8. kharris

    Dick,
    We have no particular reason to believe that transitions to new technology or new sources of energy will occur just as needed to prevent economic disruptions. We might even wonder whether a prolonged period of petroleum prices substantially higher than those we face today could be needed to spark those transitions. If so, then the situation Anarchus describes seems pretty likely during the transition. “Smooth” is not a word that jumps to mind when thinking about past transitions.

  9. algernon

    Foreign central banks may have shifted some their purchases to short-term Treasuries of other $-denominated assets.

  10. DickF

    kharris,
    It seems to me that our choice is Fascist central planning forcing people to accept the energy choices of a small bureaucracy that will artifically force resources to existing technology hampering innovation, or we can allow freedom of consumer choice and freedom of markets to innovate to compensate in whatever direction people choose.
    Central planning can only be backward looking. Those who fear the free market trade the innovation of the entrepreneur for the static status quo of the manager.
    It is true that we will never know the innovation of tomorrow just as those in the past never knew the innovations of today, but the buggy is gone and today we need oil. Tomorrow’s personal transportation will be as different from today’s as the horse and buggy are from the internal combustion engine.
    Serious consideration of the innovations of the past 30 years are astounding. The only reason we have no new method of transportation is because the current methods are so efficient and cost effective.

  11. JDH

    Charlie and Anarchus, I have a hard time seeing why an increase in real oil prices would simultaneously produce a rise in real U.S. interest rates and a rise in the relative value of the dollar. I think the conventional wisdom is that the accumulation of petrodollars may have been part of the “global savings glut” which produced low global interest rates.

  12. Charles

    I think you may be reading too much into relatively short-term data. There are a number of points I would consider:
    1. Granting your point that the Euro/dollar does not seem to fit a pattern of declining demand for the dollar, the currency markets do not appear to me to be driven by fundamentals. Rather, trades are being driven by technical analysis (i.e., very short-term factors; speculation). The yen carry trade may be driving the dollar to unrealistically strong levels.
    2. Purchasers of long bonds are intensely inflation averse. Purchases of shorter-term yields are much less sensitive. I’d like to see historical data before deciding that six weeks is an appropriate response time for a yield differential to emerge or that a few bps is significant. Looking at the Smartmoney Living Yield Curve, we see a flat curve in September 1989, which bounces around for a while before resolving into a rising yield curve a year later. Similar in reverse August 1978-September 1979.
    3. Investor behavior can be irrational. Without either exaggerating or minimizing the fallout from the CDO crisis, optimism for growth in the economy assumes no war or other serious disruption of oil, no radical change in the situation in Iraq that could disrupt US military obligations elsewhere, full containment of the subprime meltdown, no hedge fund meltdowns in other areas, no constitutional crisis that could paralyze government, no dollar crisis, etc. It may happen, or at the least, crisis may come later rather than sooner.
    Or maybe not.

  13. dryfly

    Sorry dick, the “free market” is a intellectual term, not a real term. There are managers EVERYWHERE, that includes in the “free market”. Your utopion illumanti driven mumble garb would simply create imbalances and monopolies replacing the existing monopolies that have been created today. My guess, then you would understand, but it would be to late.

  14. DickF

    dryfly,
    Monopoly is virtually nonexistent without government interference. This is why there is an unholy alliance between big business and government. Big business uses the coercive power of the government to eliminate the competition.
    If you do not believe this then I suggest you look at the top five corporations for the decades of the 20th Century and the effect of competition will become obvious. And if you dig a little deeper you will find the government connection.
    The term “free market” is no more utopian than the term moral. It is a goal not a condition. You can be immoral if you want, just as you can be anti-free market.

  15. DickF

    kharris,
    There is blind faith and their is informed faith, but all is faith whether you “believe” it or not. when dryfliy states, “Your utopion illumanti driven mumble garb would simply create imbalances and monopolies replacing the existing monopolies that have been created today” it is blind faith in central planning rationalizations.
    I am open to examples of monopoly that do not arise from government intervention (please, no natural resources. I will give you that) Just to be balanced here are a few government monopolies. Education, Cable TV, utilities – that is the low hanging fruit.

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