The Tail Wagging the Dog
03/31/08
The chart above shows the yield of 10 year T-Bonds (blue) and 30-year T-Bonds (magenta) and the difference between the two (green). It shows you the extent of complacency that existed in the credit markets until summer of 2007 and then the increase in risk aversion afterwards. Notice how the spread hovered around 0.1% and 0.2% during the first half of 2007 and how afterwards the spread increased in waves to its recent high of 1%. The difference between the two bonds can be viewed as a proxy for risk aversion. 30 year T-bonds are 20 years further removed from the fed funds rate set by the Federal Reserve than 10 year bonds. Nevertheless, both belong to the long end of the yield spectrum and (broadly speaking) both are used for similar purposes by institutional investors. So, if an investor needs to match long term liabilities with long term assets (such as long bonds) and he is increasingly risk averse, he may use 10-year bonds rather than commit himself for 30 years. Rising risk aversion thus translates into less demand, falling prices and rising yields on 30 year bonds. Most investors use 30 year mortgage bonds rather than 30-year T-bonds as a yardstick for risk aversion, but T-bonds work just as well in my opinion and they are easier to track. You can see that the yield difference between the two bonds has shrunk since March 10. No doubt the Fed actions are having the effect of reassuring market participants. On March 19 Fannie and Freddie were also allowed to lower their surplus capital requirements from 30% to 20%. Then, on March 24 the Federal Housing Finance Board allowed a temporary increase in the amount of agency mortgage debt that the Federal Home Loan Banks can purchase. In addition the Fed expanded its term auction facility to $100 billion from $60 billion and introduced a term securities lending facility that offered Treasury securities to primary dealers secured for 28 days by a pledge of other securities including agency mortgage bonds. All these measures seem to slowly unclog the credit markets. Some of that may have already been evident in the March 21 week when refinancing tracked by the Mortgage Bankers Association jumped over 80% and refinancing accounted for over 60% of loans processed by lenders. The chart above shows you the spread between the 2-year T-note and the 10-year T-bond. As discussed in a previous newsletter this yield difference is a proxy for the profitability of our banks. Banks are always borrowing short, currently paying on savings accounts and CDs something like 2% as approximated by the 2-year yield and lending long by receiving 4% and over for consumer loans, mortgages and business loans. The green line shows you the degree of profitability. You can imagine that banks in 2006 and 2007 were not exactly printing money, since the green line actually went negative for a while. In order to stay profitable, many of them were forced into risky business ventures like sub-prime mortgage origination or leveraged loans to finance takeovers. These strategies backfired and we now have to clean up this leveraged mess. While leverage actually did enhance banks profitability during times of risk affinity, it destroyed that banks profitability during times of risk aversion. The unwinding of the global leverage trade is going to take a while longer. Just consider that global GDP amounts to some $50 Trillion, whereas the tail that wags the dog consists of $500 trillion in derivatives. Hermann Vohs
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. |