Daily Market Reports | May 28 2009
By Greg Peel
The Dow fell 173 points or 2.1% while the S&P fell 1.9% to 893 and the Nasdaq fell 1.1%.
China is not happy with the US. As a holder of hundreds of billions of dollars worth of longer term US Treasuries – the re-investment of foreign reserves gleaned from its export industry – China stands to lose big time if the rampant printing of currency sends the US dollar over the edge. Resultant inflation would send prices of longer term bonds lower as nominal yields need to rise to overcome the erosion of value of interest payments due to inflation.
China has little choice but to support US Treasuries nevertheless, for if it were to sell its holdings it would itself be the cause of the sell-off it fears. However, were China to move its bond exposures to the short end rather than the long end, the impact of inflation is reduced. That is exactly what China has suggested it would do and exactly what it is doing.
On Tuesday night a US Treasury issue of 2-year notes was three times oversubscribed. Last night a solid issue of 5-year bonds was also well sought after. Of the bonds sold, 44% went to “indirect bidders” which includes foreign central banks. This is a very high proportion, and confirms Chinese buying. But if China is withdrawing to the relative safety of the short end, the long end is thus left flapping in the breeze, and this creates another problem.
Unlike Australia, in which mortgage rates are based off the RBA overnight cash rate, US mortgage rates are more sensibly linked to the maturity they represent. The 30-year bond is considered the benchmark for mortgages, but realistically many mortgagees attempt to pay off their houses a lot quicker than that. Hence, bond maturities of 10 to 20 years are where a large concentration of anticipated mortgage maturities lie.
The lower the prevailing interest rate, the faster mortgagees are expected to be able to pay off their loans. As interest rates rise, expectations are that mortgagees will now take longer to get to the final payment. Buyers of mortgage securities hedge their positions by selling the appropriate US Treasury. The idea is to be long the higher-yield mortgage security and short the lower yield Treasury and profit from the margin. In recent months, the yield on the 10-year bond has blown out from 2.5% to 3.5% as bond investors have begun to fear a weakening US dollar and increasing inflation. This effectively raises mortgage rates but also increases “duration” – the time expected for mortgages to be paid off. If duration increases, you need to roll out to longer dated US Treasuries as a hedge.
So to sum up, China is effectively buying short-dated bonds and not long dated bonds as it used to, and mortgage traders are having to buy back their shorter term hedges and sell longer term hedges as the yield on the 10-year bond rises. The result is the yield curve is steepening, and last night it steepened rather dramatically. A rush out of 10-years sent the yield up 17 basis points to 3.72%. The yield on the 2-year note ended at a steady 0.97%, meaning the 2-10 spread is now 275bps – as high as it’s ever been.
The irony is that a steep yield curve is usually considered good for banks, as they can borrow at the short end and lend to the long end at a good margin. But rising longer term rates threaten to derail economic stimulus, given mortgage rates – which the Fed has been trying so hard to push down by directly buying mortgage securities – are rising again. And that is not good when foreclosures are still on the rise, along with unemployment.
Moreover, the higher bond yields rise the more attractive those yields become to investors concerned about inflation. Inflation also erodes the return on stocks and stock dividends. If the bond market is paying a better, safer return, why hold stocks?
And that, my friends, is why the Dow was down 173 points last night.
All of the fall occurred in the afternoon following the government bond auction. Up to that point Wall Street had merely bungled along the flatline as it waited. Lack of positive momentum also belied what appeared to be some good housing data.
The National Association of Realtors announced that sales of existing homes rose by a greater than expected 2.9% in March. Two months ago, that might have been considered wonderful “green shoot” news. But Wall Street is a bit more wary now, and indeed a closer inspection of the figures revealed a picture which was not so rosy.
The bulk of sales increases was in the low-price end – meaning desperate foreclosure sales at bargain prices. This meant the median sale price fell 15% and sales in the higher range were poor. And more and more higher-price houses are coming on to the market as more and more white-collar types are forced to concede to their own unemployment. While net sales may have risen, the amount of inventory for sale rose 9%. In other words, the housing market is still going backwards.
Just to rub salt into the wounds of an already dour day, General Motors bondholders finally rejected the offer made to them by the government, meaning GM will be in bankruptcy by Monday, if not earlier.
Despite the weakness in 10-year bonds, the US dollar actually ticked up slightly as plenty of bonds were being sold in the short end. Gold thus had to fight one of those battles between stronger dollar and safe haven demand, and fell US$2.50 to US$949.50/oz. The Aussie nevertheless pulled back sharply, down 0.9 of a cent to US$0.7771, as commodity prices tumbled.
A stronger dollar was a trigger for a fall in base metals but realistically, the pending death of GM weighed heavily in London. GM is a big holder of stockpiled metals as inventories for car manufacture, and one assumes an administrator would waste little time in cashing that in. For once aluminium posted the steepest fall on the night, dropping 3.6%. Zinc fell 3% and copper was down 1.5%.
Oil, however, bucked the trend, rising US45c to US$63.45/bbl to post its highest close in seven months. It seems you couldn’t kill oil with a gun at the moment. The impetus for last night’s rally was a report from the International Energy Agency predicting oil will rise to US$110 and then US$130. Woohoo! The fact that those prices are expected to be reached in 2015 and 2030 respectively mattered not.
The SPI Overnight fell 29 points or 0.8%.
Tonight in the US is an auction of 7-year bonds.
