Friday, August 20, 2010

"Bonds as Lemons" - And US 10 Year Notes at 2.5%

Below is a comment on why US Gov't 10 year notes are at 2.5%. As a reminder I used to be a bond trader, and were I still one, I likely would have had my face handed to be for shorting 10 years long before they hit 2.5%. This piece comes from David Zervos at Jefferies. I hope he doesn't mind the reprint.

"Suppose the Congress controlled the production of all the lemons in US. Then assume the Federal Reserve decided that it was going to use its balance sheet to buy lemons as a means of adding liquidity into the market when times were tough. While the government ramped up lemon production during tough times, the Fed not only bought most of those lemons, but sent out a clear message that it stands ready to buy a whole bunch more lemons if the economy falters. Finally, suppose that the government started changing the rules and regulations forcing financial institutions to hold more lemons rather than limes - as lemons were deemed the only safe fruit. What happens to the price of lemons? The answer is a 2.50% 10 year note!

These are not “market prices”. The Congress, Fed and Treasury are controlling the supply, demand and the rules of the game in the US government bond market. And make no mistake – lemon production is ripping higher. Eventually people will realize there are not enough Corona bottles to stuff those lemons into and there will be lemonade all over the streets. Until then, please remember that this will go down as one of the greatest examples government price control and manipulation in history. Maybe soon we will be lining up at 15th and Constitution in DC - at the doors of the Treasury on odd and even days depending on our birthdays - in order to buy limited supplies of those precious lemons!! There is a great book by two gentlemen from the Hoover institution - The stories span 10,000 years but they all have one thing in common – when governments distort asset prices, bad things happen. It is an easy and fun read. I encourage you to grab a copy.

Finally, it has been a humbling summer watching 10 year rates move to these levels. I remain steadfast in the view that we are at least 75 to 100bps expensive in long term rates. But with the supply, demand and rules fixed by the Fed/Treasury/Congress Troika, I probably should have been more prepared for this – mea culpa. In any case, I’ll fall back on one of the better calls we have had and that is in MBS space where price manipulation is just as rampant. In fact, we can see that as the Fed has decided not to treat MBS like lemons anymore, they were quickly turned to lemonade. Once again my market screens are all red in MBS – days with 5yr futures down 5 tics and FBCL6.5s down 11 tics are amazing to watch. The 5.5/4.5 swap which peaked at 5-15 has fallen to 2 points since April. There is a lot of pain in the MBS world and it may be a good preview to what happens when government price manipulation schemes unravel. Good luck trading!"

David Zervos
Managing Director
Global Fixed Income Strategy
Jefferies & Co

As an add. US Treasury notes are a benchmark for all spread products. It you agree that these rates are low because of manipulation, then what is the right "spread" for anything? I argue that investors should be looking at absolute yield levels versus the risk of the bond and asking themselves, does this make sense? I don't follow debt spreads too closely anymore, but if I were an investor I would be careful. If treasury rates break down, so will spread product... bigtime.

1 comment:

Chris Gray said...

I like this from PIMCO

"As societies start to worry even more about public finances – and this is inevitable – it will become even more difficult to sequentially deploy new balance sheets in order to sustain the levels of debt and deficit that currently prevail… that is, unless there is yet another healthy balance sheet that can stealthily take on this debt for a while."

What does stealthily mean?

"Deploy new balance sheets." To the benifit of whom? At a cost to whom?

Is it a mystery whether there is ahealthy balance sheet somewhere? Are there two or three?

My mother-in-law just returned from visiting Cuba for the first time since she fled in the early 1960s from a redistributive government promising a Utopia on earth. I now have the after pictures side by side of their home and seaside yatch club. It is amazing what 50 years of "progress" has brought.

She described the double currency monetary system and what people do to gain an advantage at the expense of others.

Fortunately for her she does not see similarities in our public sector and yes, Wall Street, and the dynamics she described in Cuba. Good for her. She deserves peace.

There is nothing good about quantitative easing, but again, very clever. QE2 ue to be a ship.

Once a month I am blessed with the opportunity to listen to a man of wisdom and humility. A man of God. He said this about 4 months ago.

What happens in any nation is if the leadership of a nation is evil, then the nation is evil. Because the leadership of the nation set the stage for everything that is acceptable or unacceptable.

Hope you all are adjusting to the dry air.


Chris Gray