The Fear Factor
By Zach Berg, CFA
May 21, 2012
As if listening to a broken record that has caused listeners a splitting migraine, Greece was once again the refrain that drove yields this past week with 10-year Treasury yields coming within just under 2bp shy of their all-time lows (1.671%). The inconclusive Greek national elections two weeks ago and subsequent inability of the main political parties to form a coalition government has led to the scheduling of new national elections on June 17th and increased risk apprehension that Greece’s exit from the Euro zone may become a reality. The contagion potential of a possible Greek Euro exit invoked the fear trade, with the Moody’s downgrade of 16 Spanish banks and a Wall Street Journal article (J.P. Morgan Struggles to Unwind Huge Bets) that the JP Morgan trading loss may reach $5 billion, only added fuel to the fire. Risk aversion skyrocketed leading to a flight to quality rally, in which 7-year, 10-year and 30-year Treasury yields fell 7bp, 11.5bp and 20bp respectively. For the second week in a row, German Bund yields fell to new record low levels for 2-year, 5-year, 10-year and 30-year Bunds, while Spanish 10-year yields soared, nearly hitting 6.5% on an intra-day basis Wednesday. The shunning of risky assets left equity prices lower once again as the Dow Jones has lost nearly 910 points since its May 1st 2012, high of 13,279 and the S&P 500 Index 2012 return has been depleted from what once was a 12.84% figure to just 2.99%. Following equities lead, corporate bond spreads were under pressure as well, with the Markit CDX NA IG 18 index of 125 investment grade credit default swap spreads blowing out over 14bp on the week and their corresponding cash equivalents jumping 20bp higher, according to the Citigroup Investment Grade Index. The JP Morgan effect coupled with European banking fears stemming from reports of potential bank runs in both Greece and Spain put bank and finance spreads under the greatest stress, evidenced by the astonishing 30bp widening in those spreads, based on Yield Book figures. Last week’s trading backdrop was all too reminiscently familiar for many investors, but after the capitulation of last week investors are left with near record low yield levels for many Treasury maturities, while the liquidity concerns that have dominated previous bouts of volatility have not reared their heads. This week’s commentary highlights four observations to these points worth noting during another episode of heightened market instability.
The Front-end of the Treasury Yield Curve did not join last week’s rally
The long-end of the Treasury curve has fallen dramatically led by 10-year Treasury yields falling roughly 12bp last week and 22bp since the start of May, while 30-year yields moved over 20bp lower last week and 31bp for the month. As the chart below displays, 7-year and 10-year yields are within an earshot of their lowest levels; however, 2-year and 3-year yields remain above their lowest yields and actually moved higher this past week even as risk aversion soared.
Why are front-end yields not moving lower? The answer may be from multiple sources including higher repurchase (repo) rates and the Fed’s Operation Twist program. Repo rates dropped precipitously in early 2011, evidenced by the fall in 3-month repo rates to just 0.01% in April and spent a majority of the year trading in rough 5bp range due to the excess amounts of available liquidity as a result of the Fed’s QE2 operation ($600bln) and money market mutual fund (MMMF) demand for repos. The 0.1532% 2-year low shown above corresponded to an approximate 0.03% 3-month repo rate in September 2011. The demand from MMMF’s has subsequently decreased leaving repo rates higher (3-month: 0.17%) and establishing a quasi floor for front-end yields. Another significantly important change was the supply and demand facets of the front-end, where the Fed’s decision to embark on Operation Twist has increased the supply of 3-month to 3-year Treasuries by $400bln upon completion next month. Until Operation Twist ends in June, it appears that this dynamic is unlikely to change leaving short-term yields depressed but above their all-time lows.
The Long-end of the yield curve moves closer to record low yield levels
As mentioned above, 10-year Treasury yields came within just 1.751bp (1.6886%) of their all-time low yield level of 1.671% witnessed back on September 23rd, 2011, and 30-year yields are just 30bp above their corresponding low. With long-end yields plunging over the past three weeks, the Relative Strength Index technical indicator is flashing an overbought signal for 10-year and 30-year yields. According to Bloomberg, the Relative Strength Index measures the velocity of a securities price movement to identify overbought and oversold conditions. The graph below highlights this technical condition for the 30-year where the RSI has crossed below the green line.
It is important to note that this is just one technical indicator and with risk sentiment skewed as negatively as it is at this time, a corresponding retracement higher in Treasury yields is not a given. In fact, when looking at the RSI overbought indications during times of great stress, such as last August (circled above), the sell signal of the index produced only a minor correct and did not resulted in longer term selling pressure. If risk aversion remains extremely elevated, Treasury yields can remain at near historic levels for 10-years or even move lower on 30-years. Also aiding the argument that any correction may be brief is the record low yield levels German bunds are hitting, which should help maintain a bid for Treasuries as well. The RSI is simply displaying that the recent rapid decline is yields may be primed for some sort of correction whether minor or something greater given the markets propensity of not moving solely in one direction. This week’s supply of $99bln worth of 2-year, 5-year and 7-year paper would be an example in which historically yields have built in a supply concession equating to some varying degree of higher rates to digest the new supply.
The Yield Curve is at its flattest levels in eight months
Combining the factors mentioned above and the overall shape of the yield curve is at its flattest level since October 2011. A disregard of the technical backdrop and a continuation in rally of 30-year yields could bring the yield curve back to its flattest state in three years.
Liquidity measures are not showing strains … yet
Post Lehman, nearly all moments of market stress have been linked with increasing liquidity pressures, evidenced by increases in the TED Spread (3-month LIBOR less 3-month Treasury Bill) or the LIBOR/OIS Spread (Overnight Indexed Swap). On a positive note thus far, this has not been the case this time around due in large part to the extension of swap lines the Fed and other global central banks have put in place to keep the flows from being strained. Additionally, the two ECB long-term repurchase operations have placed a great amount of liquidity in the hands of European banks. It appears unlikely at this moment that liquidity will become a concern this time around; however, the addition of a liquidity dilemma to what has been a solvency problem would greatly exaggerate the current situation.
Investor psychology is a precarious thing as apprehension and trepidation have ratcheted higher during the past few weeks. The yield curve has flattened dramatically, while the dynamics at the front-end do not appear set to change in the near-term and the intermediate portion of the curve experiences increasing expectations of further Fed easing. Those expectations only grew this past week after the release of April’s FOMC minutes stated a shift from a “couple” members to “several” members of the Fed “indicated that additional monetary policy accommodation could be necessary if the economic recovery lost momentum or the downside risks to the forecast became great enough.” The domestic economic calendar is fairly light this upcoming week with exception of Durable Goods Orders on Wednesday, leaving whatever European breaking news headlines as potential market drivers. However, with the Greek elections roughly four weeks away and Spain struggling to stabilize its banking sector losses as its economy remains in a recession, it appears the fear factor dynamic is unlikely to alleviate anytime soon.