By Zach Berg, CFA
June 04, 2012
Yields across the globe plummeted this past week as the once unlikely thought that US Treasury yields could ever approach historically low levels reserved for the likes of Japan have been replaced by a 1.4387% intra-day low recorded on the 10-year this past Friday. Records were shattered and the history books were rewritten with all-time record lows in the UK, US, and Germany. In the US, 30-year Treasuries set a new intra-day low of 2.5089%, while 2-year German Bunds fluctuated around zero to negative yields and 30-year Bund yields actually traded lower than the comparable Japanese 30-year yield (1.666% versus 1.778%). These are strange days indeed. The narrative of this past week was one in which fear perpetuated upon itself, increasing throughout the week as risk apprehension intensified towards the Iberian Peninsula. The ensuing flight to quality rally left an abundance of excess cash chasing a limited amount of perceived “safe” haven assets. Also weighing on investors’ psyche was poor manufacturing figures across the globe, a much lower than expected non-farm payrolls figure on Friday, and the lingering trepidation ahead of the June 17thGreek elections. Investment grade corporate bond spreads blew out 5bp to 216bp after Friday’s payroll data miss, leaving the Citigroup Investment Grade Index at its highest level since January 18,2012. In government sponsored agencies, spreads moved only marginally wider, while agency mortgage backed bond spreads actually tightened 5bp on the week.
For Spain, the nation witnessed its 5-year credit default swap spreads ascend past 600bp for the first time ever as apprehension over Spanish banks mounted. The Spanish banking crisis faces a two-fold dilemma with the issue of exactly how much capital the nation needs to inject to shore up bank balance sheets representing only half of the problem, while the implementation of those recapitalizations presents their own substantial hurdles. The Spanish government has provisioned €110bln to cover banking loses; however, the Bankia bailout is beginning to be perceived as a canary in the coal mine, as bailout figures have increased from an initial figure of €4.5bln to €23.5bln. The concern that underlying losses for the rest of the sector are much greater has subsequently skyrocketed. The International Institute of Finance pegged the amount of additional capital injections needed at some €50-60bln. Currently, the Spanish Fund for Orderly Bank Restructuring (FROB) has roughly €5bln it can deploy, leaving a considerable financing hole to be filled in some capacity. One method would be for the FROB to continue to issue debt to use in the capital injections. Another would be for Spain to simply issue more sovereign debt and in turn inject that into the banks. Although, the surge in Spanish sovereign yields makes this solution very punitive and may lead to more distress on Spanish yields if it were forced to issue debt against the current backdrop. Finally, the recently much publicized, hot-button route could be a direct recapitalization of banks through the use of the European Stability Mechanism (ESM). This concept has been rebuffed by the likes of Germany and would require a reworking of the ESM’s original mandate that does not allow banks to access the fund directly, only sovereign nations. The gist from all of these European acronym soup potential rescues is that the first two approaches (FROB or Spanish sovereign issuance) risk increasing yield pressures, while the third is not a process that could be implemented very quickly and would require political cooperation, which has been challenging in the past. Hence, the stress that Spain finds itself under is unlikely to alleviate itself very quickly, possibly leading the nation further down a path of an outright bailout from the EU and IMF. Consider the chart below, which shows that given the current Bund to Spain yield differentials, a Spanish rescue may only be a matter of time.
European Union Bailouts (Spreads to Bunds as an indicator)
|Country||Date Spread to Bunds hit 500bp||10-year Yield at that time||Bailout Date|
(Source: Financial Times, Bloomberg LP, Fidelity Capital Markets)
At these times of market consternation, the Pavlov’s Dog response has become one in which the clamoring for central bank policy action grows considerably, almost anticipating that central banks will attempt to ride to the rescue once again. Domestically, Friday’s disappointing non-farm payrolls figure is likely to lead to increasing expectations that the Fed may be moving closer to further quantitative easing. Certainly, the Fed will not be encouraged by the souring of economic data and appears to be very concerned with the potential fiscal cliff approaching at the beginning of 2013 (mentioned in the last release of FOMC meeting minutes and by various Fed Regional Presidents); however, one key aspect that has yet to fully materialize has been a drop in inflation expectations to a point that may signal deflationary fears. As the chart below depicts, using 5-year/5-year forward breakeven rates, which projects what consumer prices will be in 5 years without the effects of oil swings and seasonal factors, although equity prices have fallen dramatically the current levels of inflation expectations have not reached levels that have corresponded to previous Fed interventions.
Based on the past, the chart displays that it would take a sizable, roughly 30bp decrease, to reignite deflationary fears and correspondingly bring the Fed off of the sidelines.
The chart above also highlights another aspect to a question many investors must be asking themselves after Treasury yields have marched to their new low levels. Can yields continue to fall? Recall, Treasury yields are largely composed of two components, real rates and inflation expectations. Over the past nine weeks, real rates especially for 10-year yields have collapsed substantially, while inflation expectations have lagged behind. Thus, if growth expectations continue to get scaled back, inflation expectations can fall as well, leading to even lower rates. It is important to bear in mind that at a certain level, a decline in inflation expectations is a double edged sword that leads to greater anticipation of Fed intervention to combat deflation, which would lead to greater pressure for rates to move higher on Fed balance sheet expansion. Under the current perceived market mentality, this creates a potential floor for yields with research from Barclays Capital and Bank of America/Merrill Lynch estimating that bottom to exist around the 1.3-1.4% area for 10-year yields.
So, where does that leave the bias for Treasury yields in the very near term? The pleas for some form of intervention are only likely to increase as the ECB has a rate policy meeting this Wednesday. However, with the Greek election still two weeks away, it may be unlikely for the ECB to do anything until it knows exactly whether it will be dealing with a Spanish dilemma, a Greek crisis, or attempting to try to save the entire Euro zone. It could introduce another long-term repurchase operation (LTRO) or restart the Securities Market Program (SMP) (secondary buying of sovereign debt), but another LTRO does not really address the current problems and SMP buying has been complicated by the subordination consequences resulting from the Greek debt restructuring. From a political standpoint, the next meeting of the minds is not scheduled to occur until June 22nd, when France’s Hollande, Germany’s Merkel, Spain’s Rajoy, and Italy’s Monti are set to meet in Rome. That meeting will be conducted ahead of the complete EU summit scheduled for June 28-29th. Taken together, the prospects for some form of action appears to be slim until after the Greek elections, leaving a substantial amount of uncertainty hanging over the markets and helping to provide a bid for Treasury yields at these levels.
In the US, Chairman Bernanke will deliver testimony to Congress on Thursday where he is expected to discuss the economic slowdown, the potential European contagion effects, and remind everyone that the Fed is willing and able to launch additional policy options. Outside of Bernanke, the economic calendar is fairly light with ISM Non-Manufacturing and the Fed’s Beige Book on the docket. From a technical backdrop, Treasuries appear to be overbought, including the relative strength indicator mentioned two weeks ago that continues to flash this condition. Nonetheless, just as the recent week’s nearly 30bp decline in both 10-year and 30-year yields displays, a continuation of such a heightened state of risk aversion can maintain if not drive Treasury yields even lower. Use the following support and resistance levels as guides for potential Treasury trading ranges throughout the week: 2-year (Support: 0.275%; Resistance: 0.235%), 5-year (Support: 0.705%; Resistance: 0.59%), 10-year (Support: 1.56%; Resistance: 1.44%), 30-year (Support: 2.65%; Resistance: 2.51%). Although, the recent record declines in Treasury yields have been a product of sentiment and a slowing of growth expectations, as opposed to the key deflationary downward spiral that continues to haunt Japan, few investors would have imagined Treasury yields would reach such depressed levels. Then again, with 10-year yields of the US at 1.452%, the UK at 1.529%, Canada at 1.624%, and Germany at 1.171%, the Japanese are gaining many companions in this global state of an ultra-low yield environment.