Bond Market Hangover

The Queen Mary is starting to turn as Governments around the world try to spend their way out of the hole…

Treasuries advanced yesterday for the first time in six days as the Federal Reserve conducted open-market purchases as part of "quantitative easing" campaign and demand for the 7-year note auction was strong enough to keep yields in line with expectations. This rally comes after the sale of 5-year Treasury notes on Wednesday was met with apathetic demand, with the ratio of bids to securities offered at the low end of the range, and a higher yield of 1.85% vs. 1.80%.

This rebound in demand came as a welcome relief for the treasury with total new debt issuance for the week totaling $98 billion, but the concerns linger as even larger auctions loom. To be clear, we will be able to sell the securities to finance huge budget deficits, but at what cost? The implications of yesterday’s auction are that fixed-income investors do not have an unlimited appetite for government debt earning virtually nothing.

The US is not alone in facing a push back from bond buyers. European governments are selling record amounts of debt to finance their stimulus programs. On Wednesday German officials expressed confidence that they will be able to sell 346 Billion EUR ($470 Billion) of paper this year. Germany plans to sell 45 Billion EUR of bonds and 51 Billion EUR of securities with maturities no longer than one year in Q2. The spread between 10-year and 2-year Bunds has increased by almost 60 basis points YTD and we can expect rates to continue to rise on the longer end of the curve as investor demand a higher risk premium.

Clearly, no nation is experiencing creditor exhaustion more acutely than the United Kingdom. On Wednesday, the UK’s 1.75 Billion Pounds ($2.55 Billion) 40-year bond auction failed. The failure, the first of its kind in almost seven years, is relatively easy to explain: 4.42% is simply not enough to entice investors to lock up capital for four full decades. For PM Gordon Brown, the auction failure underscores a collapse in confidence in his leadership. On Tuesday Bank of England Governor Mervyn King warned that the cupboard is now nearly bare and that there is simply no more money to spend, calling into question the hope that quantitative easing will be the elixir to the financial crisis.

In Japan, the central bank increased its purchase program targeting longer maturity bonds as Tokyo tries to combat upward creeping yields in advance of the third stimulus plan, which may entail 20 Trillion Yen in new debt issuance. With the national debt now hovering well above 170% of GDP the BOJ buyback program has the appearance of a man treading water with a bowling ball in his hands.

Given the massive supply of securities that governments globally need to sell the prospects for programs designed to artificially stimulate demand seem very unlikely to succeed for long. Right now, other markets are providing superior risk adjusted returns, driving investors to look elsewhere until yields rise.
One of our Global MACRO themes is the Queen Mary (Bond Yields) turning. She is indeed!

Howard Penney
Managing Director

Andrew Barber

Matthew Hedrick

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