-- Posted Thursday, 10 March 2005 | Digg This Article
As I prepare this short essay, the word has come down the wire services that Japanese Prime Minister, Junichiro Koizumi, has told the budget committee of the upper house of parliament in Tokyo that he believes, “’in general’ that his country should consider diversifying its foreign currency reserves”, to quote from Bloomberg.
The reaction from the bond market was immediate with bonds sinking 21 points before recovering after a senior finance minister clarified that Japan was not thinking about switching dollar reserves to euro holdings.
Let’s chronologue the occurrences leading up to this remarkable, and what I believe is a watershed development as regards the bond market.
First, we had the comments reported late last year in a Chinese newspaper that the Chinese were considering diversifying their reserves. Bonds promptly wilted on the news as did the dollar only to rebound as the official in question was hurried to a microphone. There he explained that he really did not mean what he said and had merely been engaged in detailing purely hypothetical options that the Chinese monetary authorities might consider at some point. Next, just a few weeks ago, we had the South Koreans say the exact same thing. Bonds dutifully responded by sinking along with the dollar until once again there was a hurried explanation that such diversification did not entail moving existing dollar-based reserves into euro-based reserves. Amazingly, the Japanese authorities, the very same day, stated that they had no intentions of diversifying their dollar reserves as if to second the S. Korean motion.
Now, like a bolt of lightning out of a clear, blue sky, Koizumi comes out publicly to state that diversification is a serious option that should be considered, in effect, contradicting what his same government had declared less than a month ago.
Consider what is taking place here – within the span of a few months, we have the second largest holder of U.S. Treasuries (China), followed by the fourth largest holder (S. Korea), and finally the largest holder (Japan) among nations, spilling the beans and admitting in public that they are becoming nervous as they watch the U.S. Dollar continue to sink on the foreign exchange market and with it the value of their massive dollar-based reserve holdings.
The truth, the way I see it, is that it is too late for any public retractions or “clarifications” at this point– the cat has been let out of the bag and it is not going to go back in. There is an old adage that “wherever there is smoke, there is fire”. The smoke has been pouring into the air surrounding the bond market now for the last few months and every time it appeared as if the flames were ready to be revealed, water would come out of the authorities’ mouths to apparently quench it. In spite of all their efforts however, the fire has been quietly smoldering beneath the surface ready to break out in a moment’s notice. I believe that the moment is soon approaching.
Simply put – the Asian Central Banks are no longer comfortable holding such huge percentages of their massive reserves in dollars and are attempting to find a way to extricate themselves from the very situation that they have created by their own misguided currency policies. By artificially capping their domestic currencies – the Chinese with their hard peg and Japan and S. Korea with their quasi-pegs – they have created massive imbalances in the composition of their reserve holdings which are now bleeding red as the dollar loses its value on the world currency market. They are stuck holding a deteriorating asset and want out – there can no longer be any doubt about this after this evening’s development.
The implications to the U.S. economy are enormous. It has been Asian Central Bank buying of U.S. Treasuries that has kept U.S. interest rates artificially low and thereby served to perpetuate the massive consumption frenzy that currently marks the post stock market crash of 2000. It has further spawned a real estate and housing bubble and served to blow the U.S. Trade Deficit into the stratosphere. I do not need to dwell on this as it has been covered in detail by myself and many others and it would be redundant to do so. That is not the point I wish to cover.
What I do want to call your attention to however are two developments that have been taking place in the bond market as a result of not only the above occurrences but other factors as well. First is the spread between the 2 year note and the 10 year note. Second is the yield on the 10 year T-bill.
Please observe the following chart where you will find a graphical illustration of this spread going back to the beginning of 2002. What I would like to call to your attention is the recent double bottom in the spread at .70 and the subsequent chart action that has occurred. While I might possibly be a bit too early in categorically calling for a bottom in this spread, the current technical posture strongly suggests that we have seen an end to what is referred to as flattening trades or “flatteners” and the beginning of steepening trades or “steepeners”.
Why this is significant I will explain in a moment. Before doing that, let me give a very brief definition of what “flattener’s” and “steepener’s” are.
A flattener takes place when the yield on longer dated issues moves up at a slower pace than the yield on shorter dated issues while interest rates are moving up. Also, it occurs when on a move down in interest rates, the yield on the longer dated issue moves down at a faster pace than the yield on the shorter dated issue while both are moving down together. Lastly, it can also occur if the yield on the shorter dated issue is moving up while the yield on the longer dated issue is moving down. Whatever movement of yields between the longer dated issue and the shorter dated issue that results in a NARROWING or FLATTENING of the spread between them, is a flattener.
In other words, if interest rates are rising and the 2 year yield is rising faster than the 10 year yield, the spread is narrowing along the yield curve or “flattening”. If interest rates are falling and the 2 year yield is falling at a slower rate than the 10 year yield, the curve is flattening. Also, as has been the recent situation, if 2 year yields are rising while 10 year yields are falling, the spread is narrowing or the curve is becoming flatter.
To understand a steepener, simply reverse the description and look for a WIDENING of the spread between the longer dated issue and the shorter dated issue.
Now refer to the chart once again and you will see that since July 2003, the yield spread between the 2 year and the 10 year has been flattening. We are talking about a period of 20 months, just shy of two years, where this particular trade has been pretty much a one way bet. The down-slope of the spread line has practically been uninterrupted; that is, until this week. For the first time, we have what appears to be a bottom in the spread at the .70 level.
Why is this significant? Answer – because the raison d’etre for flattening trades has been the notion that there are no serious signs of long term inflation on the horizon and thus bond investors were comfortable putting their money at risk in return for a minimal inflation premium for the distant foreseeable future. While a great deal of the narrowing of this spread can be attributed to the carry trade, in my opinion, that was insufficient in and of itself to explain what I considered to be a complete disconnect from reality that has been occurring in the bond market.
I had written a previous essay entitled, “Alice in Bonderland”, in which I remarked that the bond market had become a place in which reality was no longer being reflected. My reason for stating so was due to the inflationary implications of the collapsing dollar and the rising CRB index which the bond market seemed to be ignoring. As long as the flatteners were the rage, it was obvious to me, no matter how much I disagreed with its assessment, that the bond market was looking for a deflationary type scenario and did not view the threat of inflation seriously. From where I was sitting it seemed to me that bond traders had bought the fictitious line being parroted by Greenspan and the various Fed governors that “inflation was well contained”, “well anchored” or “well managed”. As I observed the soaring price of crude oil, steel, copper, concrete, nickel, zinc, molybdenum, indium, uranium, coal, and a host of other various commodities, it was only a matter of time before such costs would be reflected in various business and consumer products.
Since it is common knowledge to all but those who are willfully ignorant that the feds massage the data that goes into the construction of the CPI and deliberately understate it, I assumed the bond market would see through the phony CPI numbers as they observed the rising CRB index in conjunction with a falling dollar and would take long term rates higher. They did not. Instead it appeared to focus on wage and jobs issues and opted to see no inflationary threat due to the influence from outsourcing to China, India and other parts of Asia and poured on the flatteners actually taking long term rates lower as if anticipating the dreaded deflationary scenario.
From where I am sitting, in one week, this has all changed. It now appears, at long last, that the bond vigilantes have finally awakened from their long winter hibernation and have come out growling and in a surly mood. Perhaps it was the CRB index making 25 year highs that they could no longer ignore. Perhaps it was the idea that the big buyers of Treasuries, the Asian Central Banks, were no longer to be automatically and mindlessly counted on to do their magic and bid up the bonds. Perhaps it was the sinking dollar heading back down to the increasingly critical support region near the .80 level. Whatever the reason, the flattening trade appears to have reached an end for now.
I have included the same spread chart in two different formats that I also employ in my trading and have previously written about; Kagi and Renko. Please observe that both-styled charts are generating buy signals which is translated into lifting of flatteners and initiating of steepeners. The Kagi chart in particular is very telling as the double bottom becomes very obvious when employing this particularly methodology. As I have mentioned when writing about both of these styles – they are not particularly useful in choppy or range trading markets but excel when attempting to detect longer term trends. One look at either chart therefore says it all.
The second development I wish to briefly mention is the actual technical breakout of the 10 Year Note on the charts. Please refer to the following chart as you read my remarks.
Notice that since September of last year (2004), the yield on the 10 year has dipped three times to the 3.97-4.00% level. Each time that is has, the market has rejected the low interest rate and yields on the 10 year have subsequently moved higher. What was particularly distressing to me was watching the yield on the 10 year FALL back to that level beginning in December of last year even as the Fed was making a point about raising short term rates and even considering removing the magic word, “measured”, from its vocabulary when referencing its pace of hikes. The guys putting on the flatteners were so busy buying the long end of the curve and selling the short end that they succeeded in pushing the 10 year yield down while the two year was actually rising in yield. The deflation proponents found their voice as a result and were at it once again with predictions of collapsing interest rates and a new bull market in bonds. However, once the 10 year approached the 4.00% level, it was rejected and shoved north.
This time something different happened. It did not merely go up to the 4.40% level and then move back down. On the contrary, it SMASHED through the resistance in place and has moved up sharply, now threatening to take on the 4.60% level. In other words, it appears that long term interest rates have bottomed. Since most conventional mortgages are geared to the 10 year note, it appears that we have seen the low in mortgage rates for what could be a very long time. If this is the case, and based on the current chart, it certainly does seem that way, then we might begin to see what could be the undoing of the real estate bubble. Certainly holders of adjustable rate mortgages have good reason to be concerned.
Should the steepening trades come into vogue along with a corresponding continued rise in the 10 year yield, it should finally lay to rest the deflation scenario which I personally believe was based on flawed analysis. Rising long term rates and a steepening of the yield curve are not deflationary signals – they are signals that the bond market is concerned about inflation and is putting risk premium back into the longer end of the curve to compensate investors for use of their money. As usual, time will tell.
Dan Norcini
March 10, 2005
Dan is a professional off-the-floor commodity trader residing in Texas and can be reached at dnorcini@earthlink.net with comments.
-- Posted Thursday, 10 March 2005 | Digg This Article
