SIGNIFICANT CLUES

Rising Treasury yields in spite of last week’s benign CPI and higher jobless claims numbers and this week on a lower ISM number, gave us important clues to a possible shifting construct in the bond market. We’re now witnessing bond selling in spite of soft economic numbers – an important clue. On a purely technical perspective, bond price action has changed markedly over the last few weeks. Bouts of retail buying in the morning are now met with selling throughout the day as opposed to vice versa.

The possible reasons for this shift in perception are plentiful. Was it tough talk from Korea? Or perhaps the recognition that finally, foreign central bank dollar diversification rhetoric is fast becoming dollar-diversification reality? How about the recognition that the Fed is more hawkish than previously thought? Have the bond vigilantes finally woken up – soured by a paltry yield that didn't justify growing market risk? Or am I just making too much out of recent price action, as the recent surge in yields is just another technical bounce?

Whatever the reason, price is king, as it is the final arbitrator. Price validates our views and confirms our suspicions. Unlike the surge in Treasury yields in Jun 02 and Mar 03 – a surge built on the prospect of solid economic growth – a potential surge today would be built on more ominous reasons. While it is too early to tell, could further bond price deterioration in spite of soft economic numbers confirm the start of the unwinding of, say, FCB held U.S paper, and with it the unwinding of the highly-leveraged U.S consumer?

Watch for more divergence Friday, as more bond selling (rising yields) after a soft Friday employment number could be very problematic.

Comments

[Yusef Hydrogaster]

I wonder what the unwinding of the highly-leveraged consumer will look like. Thus far, I have assumed that we'd first see evidence of this phenomenon in some other movement than that of bond yields - a major drop in consumer confidence, for example, might be a leading indicator that the consumer realizes that credit has been " maxed."

I don't know anything about how the finance industry has hedged its exposure to the extraordinary amount of consumer credit that it has bestowed upon the American public. Who takes the risk here, and how? Were you thinking that the risk was dispersed into the bond market when you hypothesized a link between rising yields and the consumer credit situation?

All of my credit cards have low and fixed interest rates - as long as I am not late on a payment or make some violation of the credit agreement. If I do make a mistake - wow. A huge increase in my interest rates, as well as a hefty fine as a penalty.

[psh]

'how the finance industry has hedged' ?

With the bankruptcy bill.

[Yusef Hydrogaster]

That's a good one, psh.

I wonder how effective enforcement of any law will be when and if the number of offenders is a high percentage of the population.

I also can't help wondering if the American consumer has some such strategy as a "hedge" - if everyone is bankrupt at once - everyone is off the hook, at least as far as the law, or direct economic consequence.

[psh]

I meant it. Seems likely it will happen on the margins, but what makes me nervous is bond fund managers reaching for yield with ABSs. I'm hanging onto one short-term bond fund, waiting for convexity to ease my pain, but by now it's >50% ABSs. Gives me the willies.

[Uday]

Fixed rates are indeed a hedge against raising yields, as is federal aid, as psh pointed out with bankruptcy protection (although less of a hedge than a loophole – something in need of a major overhaul as abuse is widespread). The finance industry is a big believer in derivatives to hedge risk. Of course derivatives are contracts between two parties, each taking an opposite side of the trade – so counterparty risk is huge. So essentially, if one wishes to hedge risk, another must assume risk. It's a zero-sum game.

As far as “who takes the risk here”...that’s hard to say. Risk is distributed so many times over as it packaged, repackaged, stripped, and packaged again. So while we can’t say for certain who holds or assumes it, we can say there’s a lot of it.

And yes, fund managers reaching for yield is a huge concern. Institutions have become all too dependant on the ease of steep yield curves and the carry trade.

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