A dangerous signal flashes red
An insightful presentation by South African analyst, Prof JP Landman earlier this week explained to us many things we already know. Running briefly over the economic events of the past five years. He first sketched the Great Imbalance, leading his audience forward to what must still transpire, i.e. the Great Correction.
Professor Landman was brought to Windhoek by the local leg of Old Mutual’s asset management business, OMIGNAM, to try and tell us what he thinks any investor’s strategic approach should be. But is was after his delightful (blunt) portrayal of world economic developments, responding to a question from the audience, that he grabbed my attention.
He was asked for tangible signs that will herald the Great Correction and as any skilled analyst he told us what must happen, but not when it will happen. As a matter of fact, I found his response both reasonable and responsible. One of the aspects that he singled out is the movement of real interest rates. And I have been watching with some concern the direction of yield on the US 10-year Treasury Bill.
In the period immediately after the financial crisis, the US 10-year yield ran in the region of about 4.25%. Then for most of 2009 and 2010 it followed the intentional reduction in US short term rates lower hovering around 3.25%. But it was only during 2011 and 2012 that it finally became the victim of the combined onslaught of zero interest rates and massive stimulation through the one QE intervention after the other. These rates move on a daily basis but such moves are typically measured in hundredths of a percentage point. When large movements occur, they either reflect underlying liquidity or expectations. So from the last quarter of 2011 through the second quarter of 2013, the US 10-year Treasury Bill hugged the 1.6% yield line. About five weeks ago, this pseudo equilibrium was severely shaken and the yields started climbing rather briskly to the 2.6% level. During last week and again on Thursday this week it briefly touched the 2.75% level before settling back at 2.6%. And this is where I believe the learned professor’s observation on possible triggers and signals, becomes very relevant.
The US 10-year Treasury Bill is perhaps the most-traded financial instrument in the world. Its movement is a direct reading of liquidity conditions, and more importantly, of future expectations of investors. Admittedly the wild upward swing witnessed over the past month and a half may be due to the Federal Reserve’s signalling that it would start considering tapering the QE bond buying programme, but I doubt that is the whole picture. If, for instance, I compare the yield on the German 10-year Bund, I notice that despite all the gyrations evident in European markets, this benchmark bond still comfortably remains in the 1.6% region. So, it is not unreasonable to look for reasons other than market sentiment, to try and fathom what has jolted US market so severely.
I believe the reason lies in the fundamentals, at least of the bond market, and particularly of the US bond market. An increase in yield from 1.6% to 2.6% is equal to 100 basis points, or a real increase of about 60%. And I believe every single bond investor has made his own calculations on US debt, US GDP, yields on US government paper, and on what is sustainable, and for how long. The implication of this latest move is that investors, first of all, expect real interest rates to rise, and secondly, the massive capital inflow into the US bond market, may be coming to an end.
Now, this is a very dangerous statement to make without substantiation but it is also a possibility that one can not simply ignore because its ramifications are so big. If it would cost the US government 60% more in interest to service the massive debt it has issued under the QE programmes, then every rational person must ask himself, what level signals the end of the party.
A similar scenario played itself out in southern Europe’s capital markets where yields of around 6% were considered critical before the interest on that debt became unmanageable. I am sure many investment managers are tasking their analysts to come up with all sorts of models and scenarios to try and determine at what level (as signalled by the US 10-year TB), US public debt becomes a direct threat.
I am not dogmatic about the direction or the outcome of US real interest rates, but I can not be blind to the fact that other analysts (like Prof Landman) also regard the signals from the US bond market as a key indicator of when the Great Correction may start. At this point, if the market persists to move against US government debt, or at least against artificially low short term rates, it may just be the beginning of the Great Correction.