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     Jul 8, '13

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Mispricing risk
Commentary and weekly watch by Doug Noland

Bonds have been taken out to the woodshed, again.

US bonds were crushed on Friday on the back of stronger-than-expected payroll data. Long-bond yields jumped 21 basis points (bps) to an almost 23-month high 3.71%. Ten-year yields rose 24 bps to 2.74% - the highest level since August 5, 2011. Yields on benchmark mortgage-backed securities (MBS) surged 30 bps during the session to a 23-month high 3.69%. The spread between 10-year Treasury yields and benchmark MBS widened six on Friday to a one-year high 95 bps. Notably, MBS yields were up 75 bps in 14 sessions and 140 bps since May 1.

June 29 - Financial Times (Robin Wigglesworth, Michael

Mackenzie and Josh Noble): "Central banks sold a record amount of US Treasury debt last week while bond funds suffered the biggest ever investor withdrawals as markets shuddered at the prospect of the US Federal Reserve ending its quantitative easing programme. Holdings of US Treasuries held at the Fed on behalf of official foreign institutions dropped a record $32.4bn to $2.93tn, eclipsing the prior mark of $24bn in August 2007. It was the third week of outflows in the past four. Private investors are also dumping fixed income. Bond funds tracked by EPFR Global, a data provider, saw total redemptions of $23.3bn in the week to June 26. US funds were the worst hit, with withdrawals totaling $10.6bn, but emerging market debt funds also saw record redemptions of $5.6bn."

With unprecedented outflows from the bond complex coupled with notable global central bank selling, the bubble in US fixed income would appear in serious jeopardy. And while analysts and money managers will continue talk of a "fair value" range for Treasury securities, for the time being flow of funds analysis trumps valuation. Will foreign central banks continue reducing their enormous holdings of US Treasury and Agency securities? How much leverage has accumulated throughout US fixed income - especially in corporates, MBS and municipal debt? How long until some hedge funds are in trouble? Redemptions coming? Derivative problems? Will investors continue their retreat from US fixed income mutual funds and exchange-traded funds (ETFs)?

A few data points are in order. Since the end of 2007, Rest of World (ROW from the Fed's Z.1) Treasury holdings have jumped $3.325 trillion, or 140%, to $5.701 trillion. Over this period, "official" central bank Treasury holdings were up $2.233 trillion, or 134%, to $4.059 trillion. I have previously highlighted the extraordinary expansion of central bank international reserve assets (as accumulated by Bloomberg). Since the end of 2007, international reserves have inflated $5.061 trillion, or 84%, to $11.122 trillion. The Fed's $85 billion monthly QE suddenly doesn't seem as powerful.

Ongoing selling by foreign central banks could be driven by two key dynamics. First, one would think (thinly capitalized) central banks would seek to contain losses on their outsized bond holdings. Keep in mind that the higher bond yields jump, the more individual central banks will need to monitor the scope of losses and the degree of capital impairment. Second, "developing" central banks will most likely be forced to sell Treasuries and other bond holdings to fund investor and "hot money" flows exiting their markets and economies.

A prominent bullish view has held that emerging market (EM) central banks built up robust international reserve positions (including large quantities of Treasuries) that would be available to backstop their systems in the event of global market turbulence. Well, a surge of outflows (and currency market intervention) coupled with a spike in yields is now in the process of depleting reserves much more quickly than anyone had anticipated. There is a clear possibility that we're early in what could be unprecedented flows seeking to exit the faltering EMs. Recalling the 1997 Southeast Asian experience, it was a case of "those who panicked first panicked best". The more reserve positions were depleted, the faster "hot money" ran to the rapidly closing exits.

As a rough guide, the pain and dislocation associated with a bursting bubble are commensurate with the degree of excess during the preceding boom (traditional "Austrian"-type analysis). And I'll be the first to admit this is not the first occasion I've believed the US/global bond bubble was in trouble. Timing a bubble's demise is always a challenge (at best) - especially in an environment of epic central bank liquidity support. But this time has a different feel to it.

Importantly, the longer the inevitable day of reckoning is delayed the worse the consequences. Years of aggressive market intervention ensured a most protracted period of unprecedented excess - excesses that encompassed virtually all markets and all risk categories. Perhaps Federal Reserve policymaking ensured that the greatest bubble excess and market distortions materialized in perceived low-risk (fixed income and equities) strategies.

"The danger of mis-pricing risk is that there is no way out without investors taking losses. And the longer the process continues, the bigger those losses could be. That's why the Fed should start tapering this summer before financial market distortions become even more damaging." Martin Feldstein, Wall Street Journal op-ed, July 2, 2013.

I appreciate Mr Feldstein's focus on "the danger of mispricing risk" - I only wish this would have been part of the monetary policy debate starting a few years back (before the damage had been done). I would argue that never has so much mis-priced debt been issued on a global basis. Moreover, never have inflated bond prices - artificially low borrowing costs - had such a profound impact on securities and asset pricing around the world. Never have risk perceptions and market risk premiums in general been so distorted by aggressive central bank market intervention.

The mis-pricing of risk implies market re-pricing risk. And the greater the scope of mis-pricing - in the volume of securities issuance, price level distortions and risk misperceptions - the greater the scope of latent bubble market risks. Mis-pricing also implies wealth redistribution - and this has traditionally been from the less sophisticated to the more sophisticated. Actually, when enormous quantities of non-productive debt are issued at artificially high prices there is initially a perceived increase in wealth (more debt instruments at higher prices). This debt ("bull market") expansion coupled with perceived wealth creation spurs spending, corporate profits and higher equities and asset prices. But when the bubble begins to falter - with re-pricing, market losses, risk aversion and tightened financial conditions - the downside of the credit cycle commences.

I believe we have commenced a "repricing" process that will unfold over weeks, months and years - with vast ramifications and unknown consequences. With this in mind, let's at least contemplate a few near-term issues.

Various reports claim the strong market reaction to Federal Reserve chairman Ben Bernanke's policy statement caught the Fed by surprise. Despite attempts by various officials to calm the markets, bond yields have just kept rising. As such, it's now reasonable to suggest the Fed did not anticipate being on the wrong side of a spike in market yields. How much higher do Treasury bond and MBS yields need to rise before the Fed is held to account - and forced to explain - the large losses suffered in its $3.4 trillion (and ballooning) portfolio? At this point, the Federal Reserve is akin to a novice trader who keeps adding to a losing position.

Suddenly, with the potential bursting of the global bond bubble, there's a litany of important issues that come to the fore. Could mounting losses on its holdings play a role in the Fed's "tapering" timeline? Keep in mind the market perception that any jump in Treasury yields would likely ensure the Fed's ongoing QE support. Now much too complacent? What if the markets begin fretting that escalating losses on Fed holdings might become part of the debate - and provoke a less cavalier approach by our central bank - and others - in managing risk? In a way, Fed critics finally have a concrete issue to build their case around.

Market players have surely been stunned by how poorly the bond market has traded - especially with the Fed providing $85 billion of monthly support. Assuming the Fed cannot keep purchasing Treasuries and MBS forever, perhaps there is now added impetus for investors, hedge funds, foreign central banks, sovereign wealth funds and others to push liquidations forward. If money managers now realize they are holding higher risk exposures than desired, it might be advantageous to make necessary portfolio adjustments prior to the Fed winding down its QE operations.

If foreign central banks have begun a process of reducing bond holdings, does this accelerate hedge fund selling? Are the sophisticated players now anxious to reduce holdings before the next wave of bond fund redemptions and ETF-related selling? How does it work when the "Masters of the Universe" - having accumulated Trillions of assets under management by adeptly playing a most-protracted market bubble - find themselves on the wrong side of rapidly moving markets?

I am intimately familiar with the bull story for US equities. Corporate profits are strong and stock valuations are attractive. Bond yields are rising because of the underlying strength of the US economy. The "great rotation". The US economy remains the most vibrant in the world. US equities are the preferred asset class for the current environment.

Well, the US stock market is an integral facet of the greater credit bubble. Massive federal deficits, ultra-loose financial conditions and artificially low borrowing costs have been instrumental in inflating profits. mis-priced debt and meager risk premiums have been instrumental in myriad financial engineering mechanisms that have inflated corporate earnings and stock prices. Abundant cheap finance has fueled a powerful global mergers and acquisition boom. If the bond bubble is indeed bursting, the markets are only in the earliest phase of re-pricing risks and asset prices.

In recent Credit Bubble Bulletins, I have stated that, at least in terms of systemic stability, it would be preferable for some air to begin coming out of US stock prices. Fine, but this would be rather un-bubble-like. With fixed income in some serious trouble, the equity market game becomes all the more critical for all the players. And perhaps this is an important "mis-pricing risk" associated with the Fed's ongoing quantitative easing: investors hit with unexpected bond losses now increase their bets on inflated stock prices. After leading unsuspecting savers into the wild world of mis-priced fixed-income instruments, the Fed will apparently ensure the public becomes overly exposed to unappreciated risks in the US equity market.

As noted in my "Issues 2013" CBB from early January: A market bubble implies bipolar outcome possibilities. Either the entrenched bubble bursts or it becomes an issue of "how crazy do things get?" If the US stock market has evolved into the speculative bubble of choice, there are a couple things the Fed might want to contemplate. First, QE may now work to spur similar late-cycle speculative excesses that are now coming home to roost throughout the fixed-income universe. Second, inflating stock prices may work to pull additional liquidity away from an already liquidity-challenged bond market. It is, after all, the nature of liquidity to seek the inflating asset market.

The S&P500 jumped 1.6% (up 14.4% y-t-d), and the Dow rose 1.5% (up 15.5%). The Morgan Stanley Consumer index gained 1.4% (up 19.1%), while the Utilities dropped 1.9% (up 5.3%). The Banks surged 4.1% (up 24.7%), and the Broker/Dealers jumped 4.2% (up 38.6%). The Morgan Stanley Cyclicals were up 1.9% (up 14.9%), and the Transports gained 1.9% (up 18.5%). The broader market was notably strong. The S&P 400 MidCaps jumped 2.2% (up 16.2%), and the small cap Russell 2000 surged 2.9% (up 18.4%). The Nasdaq100 rose 1.8% (up 11.4%), and the Morgan Stanley High Tech index increased 1.6% (up 10.4%). The Semiconductors gained 1.6% (up 24.0%). The InteractiveWeek Internet index rose 1.7% (up 17.3%). The Biotechs surged 4.1% (up 31.7%). Although bullion was down only $11, the HUI gold index fell another 5.3% (down 51.4%).

One-month Treasury bill rates ended the week at three bps and three-month bill rates closed at four bps. Two-year government yields increased four bps to 0.40%. Five-year T-note yields ended the week up 22 bps to 1.61%. Ten-year yields surged 25 bps to 2.74%. Long bond yields jumped 21 bps to 3.71%. Benchmark Fannie MBS yields surged 37 bps to a 23-month high 3.69%. The spread between benchmark MBS and 10-year Treasury yields widened 12 to a one-year high 95 bps. The implied yield on December 2014 eurodollar futures jumped 11.5 bps to 0.79%. The two-year dollar swap spread jumped 3 to 19 bps, and the 10-year swap spread gained 6 to 26 bps. Corporate bond spreads mostly narrowed. An index of investment grade bond risk was little changed at 87 bps. An index of junk bond risk declined 3 to 432 bps. An index of emerging market debt risk declined 20 to 321 bps.

Debt issuance slowed to a crawl. I saw no investment grade issues.

Outflows from junk bond funds and ETFs jumped to $4.63bn (from Lipper). I saw no junk issues this week.

Convertible debt issuers included Healthways $125 million.

International dollar debt issuers included Israel Electric $1.4bn, KFW $1.0bn, Nigeria $1.0bn, Mona Lisa RE $150 million and Tradewynd RE $125 million.

Italian 10-yr yields fell 12 bps to 4.42% (down 8bps y-t-d). Spain's 10-year yields dropped 11 bps to 4.64% (down 63bps). German bund yields slipped a basis point to 1.72% (up 40bps), and French yields declined 5 bps to 2.29% (up 29bps). The French to German 10-year bond spread narrowed four bps to 57 bps. Ten-year Portuguese yields traded above 8% before ending the week 59 bps higher at 6.91% (up 16bps). Greek 10-year note yields jumped 32 bps to 10.94% (up 47bps). U.K. 10-year gilt yields rose 4 bps to 2.48% (up 66bps).

Japan's Nikkei equities index surged another 4.6% (up 37.7% y-t-d). Japanese 10-year "JGB" yields ended the week up a basis point to 0.85% (up 7bps). The German DAX equities index fell 1.9% for the week (up 2.5%). Spain's IBEX 35 equities index rallied 1.4% (down 3.7%). Italy's FTSE MIB was up 1.9% (down 4.6%). Emerging markets were mixed. Brazil's Bovespa index dropped another 4.7% (down 25.8%), while Mexico's Bolsa was unchanged (down 7.1%). South Korea's Kospi index dropped 1.6% (down 8.2%). India's Sensex equities index added 0.5% (up 0.4%). China's Shanghai Exchange rallied 1.4% (down 11.5%).

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