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Anybody else short US 30 Bond
- Thread starter richard_m
- Start date
No, it shouldn't... Reasons: a) inflation risk premium; b) expectations of Fed activity mostly impacting the belly of the curve.
It is interesting to compare the recent UST market rally to the experience in Japan, where 10 year JGB yields have remained below 2% for the bulk of Japan's 15+ year experience with (mild) deflation.
You might ask, "if 10 year JGB yields can stay as low as 1-2%, occasionally falling below 1%, surely it might be feasible for UST bond yields to fall to similar levels?"
The differences between the ownership of JGBs and USTs are possibly the main reason why this argument doesn't and won't hold true. Around 90% of JGBs are held by Japanese, whereas a high proportion of UST issues are bought by foreigners (eg. China). The Japanese have massive savings and are happy to earn 1% in their own currency ever since the stock bubble burst in 1990, but would the Chinese be happy to earn 1% dominated in a foreign currency?
In Japan, financials have been content to borrow at 0% and pocket 1-2% carry per annum since with inflation close to zero or even negative they are earning 1-2% in real terms and no currency risk. But is US inflation going to stay close to zero? Judging from the recent increases in $commodity prices I would say the likelihood of US inflation rates staying close to zero beyond the next year or so is low.
Unless the Fed is going to buy up every single UST issue, if they cannot keep inflation close to zero for a prolonged period they can keep short term rates at 0% forever and they will still not be able to bring long term yields to Japanese levels because it won't be enough to compensate investors.
I would be interested to know what others think about the prospects for inflation in the US over the next few years...
You might ask, "if 10 year JGB yields can stay as low as 1-2%, occasionally falling below 1%, surely it might be feasible for UST bond yields to fall to similar levels?"
The differences between the ownership of JGBs and USTs are possibly the main reason why this argument doesn't and won't hold true. Around 90% of JGBs are held by Japanese, whereas a high proportion of UST issues are bought by foreigners (eg. China). The Japanese have massive savings and are happy to earn 1% in their own currency ever since the stock bubble burst in 1990, but would the Chinese be happy to earn 1% dominated in a foreign currency?
In Japan, financials have been content to borrow at 0% and pocket 1-2% carry per annum since with inflation close to zero or even negative they are earning 1-2% in real terms and no currency risk. But is US inflation going to stay close to zero? Judging from the recent increases in $commodity prices I would say the likelihood of US inflation rates staying close to zero beyond the next year or so is low.
Unless the Fed is going to buy up every single UST issue, if they cannot keep inflation close to zero for a prolonged period they can keep short term rates at 0% forever and they will still not be able to bring long term yields to Japanese levels because it won't be enough to compensate investors.
I would be interested to know what others think about the prospects for inflation in the US over the next few years...
You got a bit of a circular argument there, I think...
To clarify a little my prior post, if I told you that there was an 80-90% chance that Bernanke would still be at the helm in ten years time and that Fed Funds rate had been kept at 0-0.25% for the WHOLE of the ten year period, and then asked you,
"What would be the 'fair' yield to compensate you for holding a 10 year US T Note?"
Some would say 0.50%-1% because they would claim banks could quasi-arb the difference between the 10 year rate and Fed Funds given such knowledge, others might say, "at the very least, 10 year should yield LOWER than the current 2.5% so the bond market should rally"...
But I am arguing that this doesn't haven't to be the case. Perhaps yields of 3-4% on 10 year notes can still be justified...
If US inflation on most assets is 3%+ (irrespective of the fact this might be conveniently ignored by the Fed due to understated 'core' CPI i.e. excluding food, energy, VAT etc - note CPI excluding everything is zero!),
then a carry return of 2.5% less Fed Funds is not so great. It is not comparable to a Japanese domestic borrowing from the BoJ and earning a similar return in JGBs.
Especially if you are not US based and are exposed to the risks of holding USD, an important consideration for (foreign) buyers of USTs, less so the risks of holding JPY for (domestic) buyers of JGBs.
"What would be the 'fair' yield to compensate you for holding a 10 year US T Note?"
Some would say 0.50%-1% because they would claim banks could quasi-arb the difference between the 10 year rate and Fed Funds given such knowledge, others might say, "at the very least, 10 year should yield LOWER than the current 2.5% so the bond market should rally"...
But I am arguing that this doesn't haven't to be the case. Perhaps yields of 3-4% on 10 year notes can still be justified...
If US inflation on most assets is 3%+ (irrespective of the fact this might be conveniently ignored by the Fed due to understated 'core' CPI i.e. excluding food, energy, VAT etc - note CPI excluding everything is zero!),
then a carry return of 2.5% less Fed Funds is not so great. It is not comparable to a Japanese domestic borrowing from the BoJ and earning a similar return in JGBs.
Especially if you are not US based and are exposed to the risks of holding USD, an important consideration for (foreign) buyers of USTs, less so the risks of holding JPY for (domestic) buyers of JGBs.
Yes, so ultimately it's all just a function of your view on future inflation. If it's low (deflation), there's no reason why 10y USTs can't trade at 1%, since everyone (including the Chinese would be happy to hold them). Clearly, if inflation is high, 10y UST yield should be a lot higher.
All I am trying to say is that I see no reason to believe, here and now, QE2 notwithstanding, that US inflation will necessarily be persistently high going forward. I don't see why the US can't follow the Japanese scenario into deflation.
All I am trying to say is that I see no reason to believe, here and now, QE2 notwithstanding, that US inflation will necessarily be persistently high going forward. I don't see why the US can't follow the Japanese scenario into deflation.
Let's first set the inflation issue aside: if that worries you as a foreign buyer, then just buy TIPS since it accrues at headline CPI (not core CPI).
Now, let's talk about your core argument. While it's not an unreasonable one to make, I disagree: In the case of the US, China as well as all export intensive countries are essentially the same as domestic savers. China incurs dollar denominated reserve because of its trade surplus with the US. That can either sit at 0% nominal yield (which is a negative real yield) in cash, for in treasury bills/notes at above 0% nominal and quite possibly non-negative real yield. If the choice is between 0% yield and a positive yield, then clearly China, like the Japanese domestic savers, would take the positive yield however small.
For all the talk about reserve diversification, China cannot fully meaningfully divest its dollar reserve without causing a worsening terms of trade that hurts its exports. China's domestic demand is unlikely to replace the foreign demand for its goods in the short to intermediary terms. In order to continue its growth (on which the legitimacy of the Party is predicated), it will buy dollar assets with its dollar reserve.
Unless there is a radical change in the way central banks operate, the bulk of those dollar reserves will be in treasuries (with some agencies; though if take downs by foreign banks in the few recent FNMA and FHLMC auctions are any indication, not too much more agencies debts).
So, it appears to me that the dollar, due its status as the reserve currency and the currency in which a vast amount of demands for goods is denominated, attracts a global poor of 'savers' who have no choice (and indeed is in their interest, much as the JPY intervention has displayed) but to buy treasuries at whatever the yield.
Now, let's talk about your core argument. While it's not an unreasonable one to make, I disagree: In the case of the US, China as well as all export intensive countries are essentially the same as domestic savers. China incurs dollar denominated reserve because of its trade surplus with the US. That can either sit at 0% nominal yield (which is a negative real yield) in cash, for in treasury bills/notes at above 0% nominal and quite possibly non-negative real yield. If the choice is between 0% yield and a positive yield, then clearly China, like the Japanese domestic savers, would take the positive yield however small.
For all the talk about reserve diversification, China cannot fully meaningfully divest its dollar reserve without causing a worsening terms of trade that hurts its exports. China's domestic demand is unlikely to replace the foreign demand for its goods in the short to intermediary terms. In order to continue its growth (on which the legitimacy of the Party is predicated), it will buy dollar assets with its dollar reserve.
Unless there is a radical change in the way central banks operate, the bulk of those dollar reserves will be in treasuries (with some agencies; though if take downs by foreign banks in the few recent FNMA and FHLMC auctions are any indication, not too much more agencies debts).
So, it appears to me that the dollar, due its status as the reserve currency and the currency in which a vast amount of demands for goods is denominated, attracts a global poor of 'savers' who have no choice (and indeed is in their interest, much as the JPY intervention has displayed) but to buy treasuries at whatever the yield.
Quote from benwm:
If US inflation on most assets is 3%+ (irrespective of the fact this might be conveniently ignored by the Fed due to understated 'core' CPI i.e. excluding food, energy, VAT etc - note CPI excluding everything is zero!),
then a carry return of 2.5% less Fed Funds is not so great. It is not comparable to a Japanese domestic borrowing from the BoJ and earning a similar return in JGBs.
Especially if you are not US based and are exposed to the risks of holding USD, an important consideration for (foreign) buyers of USTs, less so the risks of holding JPY for (domestic) buyers of JGBs.
sjfan
On reflection, I think your argument is equally valid
But what if China's desire to put an end to its own domestic inflation suddenly becomes greater than its desire to keep their currency weak and in the process accumulating USD reserves (buying USTs)?
At 1-3% domestic inflation maybe it is ok to buy USTs...
Perhaps at 4-6% Chinese inflation the picture changes...an acceptance of a stronger currency to help ward off inflationary pressures
So whichever way you look at it, perhaps it all boils down to inflation, whether you are talking US inflation or Chinese inflation.
And given that Chinese inflation and a weak USD would likely lead to US imported inflation to some degree, maybe it is the Chinese inflation numbers that are the most important data of all for the UST market..?
On reflection, I think your argument is equally valid
But what if China's desire to put an end to its own domestic inflation suddenly becomes greater than its desire to keep their currency weak and in the process accumulating USD reserves (buying USTs)?
At 1-3% domestic inflation maybe it is ok to buy USTs...
Perhaps at 4-6% Chinese inflation the picture changes...an acceptance of a stronger currency to help ward off inflationary pressures
So whichever way you look at it, perhaps it all boils down to inflation, whether you are talking US inflation or Chinese inflation.
And given that Chinese inflation and a weak USD would likely lead to US imported inflation to some degree, maybe it is the Chinese inflation numbers that are the most important data of all for the UST market..?