A Japanese Mexican Stand-Off In Rates

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,



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