Moody’s ponders US downgrade

Diane Coyle, Economics Correspondent, The Independent, January, 26 1996

“American financial markets were unnerved yesterday by the news that Moody’s credit rating agency might downgrade a chunk of the US government’s Treasury bonds.”

Moody’s losing faith in Japan

Jonathon Watts, Tokyo, The Guardian, September 7, 2001

“Japan is threatened with relegation to a division of credit worthiness shared by Slovenia and Taiwan amid growing dismay about the world’s second biggest economy.”

“Moody’s Investors Service, the US credit ratings agency, said the rising risks posed by recession and deflation had prompted it to review Japanese government bonds for a possible downgrade.”

Pound Slides as S&P Signals Britain May Lose Top Debt Rating

By Ye Xie and Anna Rascouet, May 21, 2009 (Bloomberg)

In light of the many anxious moments revolving around the world, it seems we are in the next phase with regard to speculation about credit downgrades of sovereign debt.  While we like to consider this a new phenomenon, it really is just another repeating cycle.  In November of 1998, Japan’s credit rating was downgraded to Aa from AAA citing the battle with deflation and rising debt to GDP.  It then lowered them all the way to A status as the fight continued. 

The headlines continue to show the schizophrenic amount of information attempting to be digested by investors, rating agencies and the media.  Attempting to trade on this information is as trying as it gets; much like bull riding.  Cowboy Up!

We think it is time to take a serious snapshot of what is transpiring in the Treasury market as it is the axis which all other credit markets derive some sort of value from.

The Shape Shifter

The shift in the curve is profound enough over the last year, but more pronounced when we take a look at year to date.  This time period also nearly coincides with lows set in yields.  This is no coincidence as the panic buying at year-end led a widely held belief that the global economy neared collapse.  Additionally, any institution with some ties to finance (a wide number considering the percentage of profits arising from finance backed activities at the peak was profoundly higher than the next high historically) were not able to get enough liquidity to satisfy their regulators as their balance sheet deteriorated daily.

What transpired was a rewardless risk in owning Treasuries, in our opinion.  As the economy begins to stabilize, saner minds realized the pricing of risk versus reward.  The immense amount of stimulus and support will have to be funded and the future of the Treasury market is ripe with more supply than demand can meet…at least that is what most prognosticators will have you believe.

The short end is anchored as the 10 year and beyond saw the shift.  It’s easy to think that the 10 and 30 year had similar yield shifts, but do not discount that the principal side saw a near 18% drop in principal in the 10 year and a 30% drop in the 30 year. 

A shift of this magnitude happens on many fronts, but looking at the holders of Treasuries gives you a good insight into the back drop catalysts. 

According to the Federal Reserve, there still has been considerable year-over-year purchases from those who seem to get the most venom for protectionist policies.  Though, the venom has dropped a bit since the elections are well in the rear view mirror…..coincidence, we think not.  Also, the new Treasury Secretary is seen as pushing back to the countless challenges that China has thrown the new administration (currency-wise, militarily, economically, etc).

With the 30 year selling off substantially, we would not be surprised to see a bit of an uptick in foreign net purchases, specifically with the Asian private pensions.  Though it is clearly hard to be fully blown bullish on any paper currency, recall the relativity of currency trading.  You don’t necessarily have to be favoring one currency and disliking another; rather, which one are you less bearish on and initiate a bullish position versus the ones you favor even less.

A quick look at the trading year over year in debt is profound for those who follow it.  This may appear unsophisticated, yet the details point to a very profound displacement for those looking to take advantage of the flightiness of capital.

We are large proponents of the debt market over the next few years, minus cash and treasuries.  With the large amount of risk capital leaving the market-making in debt, as dealer’s hoarded cash and minimized bid side sizes, an opportunity arrived for the patient willing to allocate money towards the seemingly large number of desperate sellers.

With the health of the credit markets improving, the large amount of new issuance has reached a bit of equilibrium in the short run.  This looks to be setting up a bit of a tug of war over the summer as even the most conditioned investor is welcoming a break from the EKG test they have been thrust upon over the last 2 years. 

The large amount of liquidity in the system that is sitting behind the dam of paralysis is going to flow eventually.  The herd mentality may not translate exactly as it had done in the past because of recent history; however, where it might flow may be of extreme significance.

According to the Fed Flow of Funds and Merrill Lynch, households have the following:

$20.5 trillion in real estate

$8.8 trillion in equities

$7.7 trillion in cash and deposits

$4.1 trillion in consumer durable goods

$1.6 trillion in corporate bonds

$960 billion in municipals

$920 billion in agency debt

$273 billion in Treasury

We wouldn’t think that this would materially supplant the foreign public and private ownership of treasuries, but it could make a large dent in the estimated new issuance of $3 trillion of treasuries. 

A Rarity in Treasuries

Recent trading activity has created an interesting pattern for those looking at where potential convex trading positions may arise in the near term. 

The spread between the 30 year and 10 year Treasury has been in a fairly pronounced band over the last 20 years.  The average has been 36 bps (green line).  Using two standard deviations as an absolute channel, one notices an interesting pattern when we touch the top specifically.  The previous two periods showed a long draw down in the spread over the next 4 years.

As we mentioned above, the yield difference currently in the 30 year and 10 year are profound.  Below are two charts just showing the YTD difference.  

Conclusion

The year to date movement in treasuries has gone reasonably unnoticed by most as headlines over the next shoe to drop dominated our attention.  The move however, is very profound and will have far reaching ramifications with regard to capital markets around the world. 

The measurable metrics such as spread to treasuries and risk-free rates of returns are an easy leap.  What is more dynamic and elusive is the impact it may have on the currency and political landscape. 

Though the sell-off in the longer dated maturities has created a tremendous backdrop for financials and lending based institutions, the curve being anchored in the short end will only last so long.  The Fed will likely maintain a near zero interest rate policy for some time; well after the economic recovery has taken hold.  Many may recall the move in the 3 month Tbill jumping a year in advance of the FOMC hiking short term rates on the last go around.

There is a tremendous amount of liquidity in the market moving at glacial speeds.  There is an immense amount of financing that will be required over the short run as well.  It seems the paradox of the irresistible force is meeting the immovable object.

Disclosure

This report is provided for information purposes only and does not pertain to any fixed income security product or service and is not an offer or solicitation of an offer to buy or sell any product or service. Unless otherwise stated, all information and opinion contained in this publication were produced by Advisors Asset Management, Inc. (AAM) and other sources believed by AAM to be accurate and reliable. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and other sources may be required to make informed investment decisions based on your individual investment objectives and suitability specifications.  All expressions of opinions are subject to change without notice.

All AAM employees, including research associates, receive compensation that is based in part upon the overall performance of the firm.  AAM may make a market in or have other financial interests in any given security with which this analysis suggests may be benefited from its conclusions.  Investors should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended in this report and should understand that statements regarding future prospects may not be realized.  Past performance does not guarantee future performance.

*Chart/Graph Disclosure: This chart/graph does not reflect past or current recommendations made by AAM, should be considered an academic treatment of empirical data and should not be used to predict security prices or market levels.  Any suggestion of cause and effect or of the predictability of economic cycles or investment cycles is unintentional.  Strategic Times was created using empirical research and analysis by highly experienced market observers and is designed for educational purposes only.  This presentation should only be considered as a tool in any broker’s, dealer’s or advisor’s investment decision matrix.  Investors should consult their financial advisor when applying the assumptions of this chart/graph.

Categories: Markets

Most Recent Comments