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A Japanese Mexican Stand-Off In Rates

Tyler Durden's picture





 

Submitted by Nic Lenoir of ICAP

Every rates trader on the street knows that trading Japanese rates over the past 10 years has been the most boring job in the business. The range the JGB market has been stuck in for that period is only 10 figures wide compared to 35 figures for 10Y US treasury futures. However most of the movement in US treasuries during that period has come in the same direction... up, and we are now getting to levels where the range we can expect in the future will probably be the same as that observed in Japan. The US and certainly Europe are not in a situation were hiking rates will be a worry when it comes to paying off interest and rolling debt at the national level. However it may very well be the case for the private sector. Part of the need to leave rates at zero is obviously to fight the widening last year of credit spreads as real cost of borrowing has remained high despite the low target from central banks, but let's remember that what first pushed central banks to cut rates so aggressively was the wave of foreclosures piling up. We all know that 2010 is a heavy year in terms of the number of mortgages resetting, and higher libor rates would certainly put added pressure on the finances of over-stretched borrowers. There is also the problem of maturing commercial real estate deals that will need to be renewed. Anything that can be done to relieve the pressure on those two sectors is very likely to be at the top of the government's priority list with unemployment.

People have recently worried of a massive sell-off in US treasuries. The example of Japan says that it doesn't necessarily happen. Certainly if the pace of the deficit widening doesn't slow down the issue could come on the table, but there is enough wealth in the US to absorb supply for now. Also, if rates sky-rocketed it would be very negative for a lot of the assets owned by the wealthy, and as a result to some extent buying treasuries is a good protection against a relapse in the economy and selling pressure on the assets they own: what they need is strike the right balance, just like the Federal reserve. It's the whole problem with unwinding imbalances, there is a very fine line to walk. The Japanese stock market shows that the unwind has happened there despite very accomodative measures, a positive balance of payments, and flexible accounting for the banks with troubled balance sheets. In the process they have also driven down their savings rate to barely 0. So basically the process came at the expense of very little progress economically, a decrease in the equity market, and the destruction of the nation's ability to save. When looking at the country's CDS, rising debt-to-GDP ratio, and savings rate, it's hard to say if Japan has won its battle yet.

This is why it is very important to put the situation in the US and Europe in  perspective. Other than creating a huge bubble in emerging markets, the numbers don't add up at all: emerging markets and China cannot be the motor of the world economy yet, and while we need them to pick up consumption and save less as we start saving, sending our wealth into their stock market which cannot absorb liquidity of this magnitude is pure madness. It will go up fast and down faster leaving more damage than it brought good. This is partly why China has been protective of its domestic equity markets and worried about foreign investments after learning from mistakes of the 1997 Asian crisis. Same holds for overly confident economic prospects: unwinding a credit mess of this magnitude, and rebalancing our economy towards more domestic production and less imports will take a long time and there is no easy miracle.

In light of these considerations, we come to appreciate the range we have been trading in in US Treasuries or Bunds. The bund future has been stuck in a 3-figure range since June, and the 10Y Treasury future is currently oscillating between the 200-dma currently at 119-01 and the support joining the lows at 117-14. We will certainly exit these ranges, probably early in the new year, as they are far too tight so that we would not break out, but it is time to wonder how far we can go one way of the other. If capital markets were to abandon all bidding in treasuries is would lead us back to an accelerated unwinding of imbalances, which would be very violent economically. That is why despite all the complaining about excess liquidity, we are very likely to be trading in a range with short brutal sell-offs hurting the longs out of their carry positions and long periods of grinding lower in rates. With all the talk about not repeating the lost decade, the way our bonds trade seem to indicate we are getting there.

Good luck trading,

Nic  

 


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Fri, 11/13/2009 - 16:24 | Link to Comment . . .
. . .'s picture

This is partly why China has been protective of its domestic equity markets and worried about foreign investments after learning from mistakes of the 1997 Asian crisis. Same holds for overly confident economic prospects: unwinding a credit mess of this magnitude, and rebalancing our economy towards more domestic production and less imports will take a long time and there is no easy miracle.

------------

China is rebalancing.  By depressing the yuan, it has subsidized all manner of malinvestment, and so, China is re-balancing by destroying enough wealth through malinvestment to drive the intrinsic value of the yuan to the price of the yuan under the peg.

Brilliant policy.

Fri, 11/13/2009 - 16:39 | Link to Comment spanish inquisition
spanish inquisition's picture

How can we devalue our way to prosperity if China remains pegged? (I don't care for Kudlow, but it's a great catch phrase). Looks like an international monetary game of chicken is afoot..

http://www.bloomberg.com/apps/news?pid=20601109&sid=awHX2QPENKgQ&pos=10

 

Fri, 11/13/2009 - 17:01 | Link to Comment order6102
order6102's picture

Every rates trader on the street knows that trading Japanese rates over the past 10 years has been the most boring job in the business

we here not to have fun - we here to make money!

Fri, 11/13/2009 - 17:41 | Link to Comment Gordon_Gekko
Gordon_Gekko's picture

Repeat after me: The USA is NOT Japan.

Fri, 11/13/2009 - 18:41 | Link to Comment order6102
order6102's picture

YET

Fri, 11/13/2009 - 19:09 | Link to Comment Mr.Kowalski
Mr.Kowalski's picture

Japan is getting older and older, and their sovereign debt is 200% of GDP; their budget deficit is as big as ours is.. with an economy half the size of ours. If rates were to go up just a few points on their treasuries, Japan would be in some serious trouble. Worse, would they choose to simply roll over their holdings of US treasuries or would they cash them out to help the problem back home ??

Sat, 11/14/2009 - 01:19 | Link to Comment order6102
order6102's picture

90-95% of JGB domestic own. We borrow from ourself, and you from everyone else...

Fri, 11/13/2009 - 19:49 | Link to Comment Lionhead
Lionhead's picture

Nic, another excellent post & accompanying charts. Concise analysis with no wasted words & thought provoking insights. You "get" it. I look forward to your posts. Thanks!  Keep 'em comin'...

Sat, 11/14/2009 - 13:50 | Link to Comment Sinsecato
Sinsecato's picture

I know alot of trades/investors have been looking at the US bond markets for clues as to the outcome of the US Dollar carry trade, especially in light of the huge supply being auctioned in recent weeks.  my question: What bond market action could be seen as a positive for maintaining the carry trade?

 

Most seem to think that a lack of bid for bonds would be a negative for the carry trade --

http://www.zerohedge.com/article/japanese-mexican-stand-rates -- "If capital markets were to abandon all bidding in treasuries is would lead us back to an accelerated unwinding of imbalances, which would be very violent economically. That is why despite all the complaining about excess liquidity, we are very likely to be trading in a range with short brutal sell-offs hurting the longs out of their carry positions"

http://www.zerohedge.com/article/keeping-eye-inflation-expectations -- "If those auctions don’t go so well, and the yield on the longer end of the curve jumps, that might prompt more serious soul searching at the Fed. And uncertainty about how long the Fed will keep the spigots gushing liquidity could push some who’ve been betting on the weak dollar/rising risk trade to take a bit of money off the table."

But what about the other side... what if treasuries continue to recieve strong bids and rates remain low or even move lower?  This scenario would seem to be indicative that the shift of social mood to higher savings, less spending, and more risk aversion continues, endangering any chance at a V shaped economic recovery.

This would mean that, although the cost of the carry trade would remain low (i.e. interest expense on borrowed dollars), continued asset appreciation is highly unlikely, and that Fed liquidity efforts will continue to get stuck in bank's excess reserves rather than make it to the real economy.  This would not bode well for the carry trade, especially if the deleveraging forces seen in July though Nov of 2008 make themselves felt again, forcing most assets lower and pusing the dollar up.

So in conclusion, while the US Dollar carry trade has worked to this point in essence as a fade of the late 2008 moves, giving back much of the Dollar's gain and retracing a portion of the Stock market decline, it seems unclear how the fundamentals can be seen to support a continuation of this trade.

Any comments/thoughts on this would be appreciated.  The question i asked in the beginning is an open question, i presented my answer but am open to considering other possibilities.

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