Is That Really What Caused Rates to Spike Last Week?
The bond market remains closed today in observance of the national holiday observed for Columbus Day (which is actually October 12th). The stock market, however remains open. As to why we have this anomaly of a closed bond market and an open stock market, I haven't a clue. I'm sure you could research this on the internet and find out. But I'm kind of busy today, so you'll have to do it yourself if you're really curious.
Got all that? OK, so since bonds are taking a rest, we'll catch up on what happened last week when rates spiked dramatically.
Let's start with what you'll likely see as the explanation for this jump in treasury yields.
A Marketwatch article reporting bond expert Jeff Gundlach's views about the recent spike in treasury yields contained the following. It neatly summarizes the consensus view of rising treasury yields:
...strategists took the market’s gyrations in stride, noting that the spike in rates is a result of a healthy economy rather than any negative development.
“We view this move as a reaction to an economy that is in very good shape; an economy that should be supportive of equities,” said John Bredemus, head of capital markets for Allianz Investment Management.
A strong economy has always served as one - let's call it the "positive" - view of why rates rise. But not everyone goes for this explanation. To see some competing views, we turn to our "brain trust."
Our "brain trust" consists of individuals whose views on markets we've observed and grown to respect over the years. While some of these folks will state their views for the financial media, most don't. We pay for their services and, in most cases, have done so for years. Some have made available analysis they've published prior to our engaging them, analysis which, for example, adresses past market declines and economic crises. So we've been able to see what they had to say before, during, and after things went bad. While no one makes perfect predictions with perfect timing, we've found our brain trust folks to have been reasonably on target.
While all of the members of our brain trust have published comments about the recent yield spike, either in a regulartly scheduled publication, or in a special bulletin, we'll share the comments of one whose views present a contrary view to the consensus opinion as expressed in the Marketwatch article we quoted above. We present these with a brief comment for your consideration.
1. Rising inflation expectations
2. Lack of demand because of the need for cash
3. The high cost of hedging
Prices for various goods and services have been rising. If recent trends continue, we'll see the prices of many consumer products rise, along with the cost of gasoline, all of which will put broad pressure on consumers. It's happening, but we'll have to wait and see if it continues. If so, we'll see inflation numbers spike, further pushing up treasury yields.
The need for cash occurs when there's a growing credit squeeze and/or liqidity crisis. People need cash and have trouble getting it. For example, emerging markets which issued bonds denominated in US dollars (vs. their own currency) have had to scramble to pay the interest on those bonds as the USD has risen in value. They need to obtain dollars to meet their obligations, the value of which has risen as the value of the USD has risen. To obtain dollars, they sell US treasuries, putting downward pressure on the price of treasuries.
As for the high cost of hedging, when other countries hold US treasuries, they take on currency risk as the value of the US dollar, in which treasuries are denominated, varies vs. their native currency. So foreign holders of US treasuries typically hedge that currency risk. However, the cost of such hedging as recently spiked. This makes the holding of treasuries potentially a negative drain. In such circumstances, the treasuries could be sold, thereby reducing demand for treasureis and putting pressure on the price of existing teasuries.
But not everyone can just sell treasures. What about foreign central bank hodings? They either need or want to hold US treasuries, so they won't sell their holdings. But they will face these higher hedging costs. In addition, banks typically reduce or hedge risk going into the end of the year for regulatory purposes. Doing so costs money and causes a tightening of liquidity. With a rising cost of hedging, that likely means an increase in tightening of liquidity. In addition, given the fact that many large US entities have repatriated dollars as a result of the new tax law, this will exacerbate a shortage of US dollars that will be needed to reduce and/or hedge risk.
So there you have three other explanations for the spike in yields, each having nothing to do with a strong US economy. Do they make more sense than the consensus opinion? Instead of providing an expert opinion here, let's instead resort to some simple common sense. If the rising rates are the result of a strong economy, we have to ask whether rates have been rising consistently in response to the strengthening we've seen in the US economy since 2009. The answer to this is "No." Rates have in fact declined for long periods of time, ultimately bottoming in 2016, even in the face of economic strength. So maybe it makes sense to think that a strong economy may not be the reason for the recent spike. Maybe it makes sense to give some credence to those other three factors.
Make sense?
Got all that? OK, so since bonds are taking a rest, we'll catch up on what happened last week when rates spiked dramatically.
Let's start with what you'll likely see as the explanation for this jump in treasury yields.
A Marketwatch article reporting bond expert Jeff Gundlach's views about the recent spike in treasury yields contained the following. It neatly summarizes the consensus view of rising treasury yields:
...strategists took the market’s gyrations in stride, noting that the spike in rates is a result of a healthy economy rather than any negative development.
“We view this move as a reaction to an economy that is in very good shape; an economy that should be supportive of equities,” said John Bredemus, head of capital markets for Allianz Investment Management.
A strong economy has always served as one - let's call it the "positive" - view of why rates rise. But not everyone goes for this explanation. To see some competing views, we turn to our "brain trust."
Our "brain trust" consists of individuals whose views on markets we've observed and grown to respect over the years. While some of these folks will state their views for the financial media, most don't. We pay for their services and, in most cases, have done so for years. Some have made available analysis they've published prior to our engaging them, analysis which, for example, adresses past market declines and economic crises. So we've been able to see what they had to say before, during, and after things went bad. While no one makes perfect predictions with perfect timing, we've found our brain trust folks to have been reasonably on target.
While all of the members of our brain trust have published comments about the recent yield spike, either in a regulartly scheduled publication, or in a special bulletin, we'll share the comments of one whose views present a contrary view to the consensus opinion as expressed in the Marketwatch article we quoted above. We present these with a brief comment for your consideration.
1. Rising inflation expectations
2. Lack of demand because of the need for cash
3. The high cost of hedging
Prices for various goods and services have been rising. If recent trends continue, we'll see the prices of many consumer products rise, along with the cost of gasoline, all of which will put broad pressure on consumers. It's happening, but we'll have to wait and see if it continues. If so, we'll see inflation numbers spike, further pushing up treasury yields.
The need for cash occurs when there's a growing credit squeeze and/or liqidity crisis. People need cash and have trouble getting it. For example, emerging markets which issued bonds denominated in US dollars (vs. their own currency) have had to scramble to pay the interest on those bonds as the USD has risen in value. They need to obtain dollars to meet their obligations, the value of which has risen as the value of the USD has risen. To obtain dollars, they sell US treasuries, putting downward pressure on the price of treasuries.
As for the high cost of hedging, when other countries hold US treasuries, they take on currency risk as the value of the US dollar, in which treasuries are denominated, varies vs. their native currency. So foreign holders of US treasuries typically hedge that currency risk. However, the cost of such hedging as recently spiked. This makes the holding of treasuries potentially a negative drain. In such circumstances, the treasuries could be sold, thereby reducing demand for treasureis and putting pressure on the price of existing teasuries.
But not everyone can just sell treasures. What about foreign central bank hodings? They either need or want to hold US treasuries, so they won't sell their holdings. But they will face these higher hedging costs. In addition, banks typically reduce or hedge risk going into the end of the year for regulatory purposes. Doing so costs money and causes a tightening of liquidity. With a rising cost of hedging, that likely means an increase in tightening of liquidity. In addition, given the fact that many large US entities have repatriated dollars as a result of the new tax law, this will exacerbate a shortage of US dollars that will be needed to reduce and/or hedge risk.
So there you have three other explanations for the spike in yields, each having nothing to do with a strong US economy. Do they make more sense than the consensus opinion? Instead of providing an expert opinion here, let's instead resort to some simple common sense. If the rising rates are the result of a strong economy, we have to ask whether rates have been rising consistently in response to the strengthening we've seen in the US economy since 2009. The answer to this is "No." Rates have in fact declined for long periods of time, ultimately bottoming in 2016, even in the face of economic strength. So maybe it makes sense to think that a strong economy may not be the reason for the recent spike. Maybe it makes sense to give some credence to those other three factors.
Make sense?
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