This past week I sent a special edition Outside the Box titled "Breakpoint in Iraq." I hope that you found it to be both timely and insightful. Today's article should be equally interesting with a unique take on the behavior of bond yields. My good friend Richard Duncan thinks rates were acting a little funny over the past couple of years, and he sheds some light as to why that might have been.
Richard Duncan has worked as a financial analyst in Asia for more than 18 years, conducting research and publishing investment reports on companies, industries, and economies from India to Japan. One of the first to warn of the impending economic crisis in Thailand in the mid-1990s, Mr. Duncan worked as a consultant for the International Monetary Fund at the height of the Asian financial crisis and subsequently joined the World Bank in Washington, D.C. He is also author of the widely acclaimed book The Dollar Crisis, published in 2003. Mr. Duncan currently works for ABN AMRO Asset Management as the Head of Investment Strategy.
John Mauldin, Editor
Outside the Box
The Bond Yield Conundrum
How It Started. Why It Ended.
When the Federal Reserve began increasing the Federal Funds Rate in June 2004, the yield on 10-year Treasuries fell instead of rising. Indeed, yields remained below their mid-2004 level until April 2006, despite 15 rate hikes (see Figure 1.) Chairman Greenspan described that unexpected outcome as a "conundrum". In retrospect, it is now clear that the conundrum originated with the discovery of accounting irregularities at Freddie Mac and Fannie Mae.
During 2004 and 2005, when their accounting irregularities came to light, those two agencies were forced to de-leverage to meet new capital requirements imposed on them by their regulators. For example, Fannie Mae's balance sheet contracted by nearly $190 billion in 2005. Figure 2 shows that net debt issuance by the agencies (and the growth in the mortgage pools guaranteed by them) was either highly constrained or negative from the first quarter of 2004 up to the fourth quarter of 2005. It is not a coincidence that this is the period during which the conundrum occurred.
Figure 3 shows the net issuance per quarter by the US government during the same period.
Figure 4 adds together the net issuance by the government and the agencies, including the mortgage pools guaranteed by the agencies.
It is useful to compare the size of the United States' current account deficit to the net issuance of debt by the US government and the US agencies (see Figure 5). The larger the US current account deficit becomes, the more dollars foreign central banks accumulate and the greater their need to invest those dollars in triple-A rated, dollar-denominated debt instrument, such as Treasury and agency debt.
Of course, central banks are not the only buyers of this type of debt. They are, however, important buyers, and the ratio between their demand for dollar-denominated debt and the supply of such debt has an important impact on interest rates. That is because when not enough new triple-A, dollar-denominated debt is issued during any particular period, central banks are forced to invest in existing debt rather than in newly-issued debt. By doing so, they push up the price of that debt, and drive down its yield. As Figure 5 shows, that was the case between the second quarter of 2004 and the end of the third quarter of 2005. During that time, the amount of newly issued government and agency debt was not enough to satisfy central bank demand for triple-A, dollar-denominated debt. That imbalance between the demand for triple-A debt and its supply explains the conundrum.
Two developments put an end to the conundrum. First, beginning in the fourth quarter of 2005, the agencies, particularly Freddie Mac, began issuing significant amounts of debt again (see Figure 2). Second, over the course of 2005, private-sector issuers of asset-backed securities (ABS), such as Countrywide Financial Corporation, became increasingly aggressive in issuing debt (see Figure 6).
Central banks have become more willing to buy the debt of private-sector ABS issuers so long as it is structured to have a triple-A rating. Indeed, with insufficient issuance of other top-rated debt to absorb their growing foreign exchange reserves, they have had little choice for the last two years.
It is interesting to note that the recent growth of private-sector ABS issuers mirrors that of the agencies in the late 1990s, when the US government enjoyed a brief period of budget surplus due to high tax revenues during the stock market bubble. In these few years, the US government temporarily stopped issuing new debt, and Fannie and Freddie expanded their balance sheets to satisfy the market's demand for triple-A paper. In the more recent example, when the agencies were prevented from growing, private-sector issuers of asset-backed securities have filled the gap by quickly expanding debt issuance. This expansion, combined with renewed issuance by the agencies in the fourth quarter of 2005, explains, in large part, why bond yields finally began to rise at the end of last year, hence the end of the conundrum. Figure 7 shows that net issuance by the government, agencies and private sector issuers of asset-backed securities became significantly larger than the US current account deficit from the fourth quarter of 2005.
Looking ahead, net issuance by the Treasury Department, the agencies and the private-sector ABS issuers will all continue to influence the direction of market-determined interest rates. On 15 May this year, the Treasury paid out $79 billion (or $45 billion net) in principal and interest. That was the largest net payout on record, and it is very likely that it played a role in the pull-back in 10-year Treasury yields from 5.2% to 5.0% over the following days, despite the-higher-than-expected consumer price inflation figure released on 17 May. In the coming months, however, the Treasury will once again return to significant net issuance, despite stronger-than-expected tax revenues. As a result, no further downward pressure on interest rates should be expected on this front.
On the other hand, debt issuance by the agencies is likely to become more muted compared with the last quarter of 2005. At the end of May, Fannie Mae entered an agreement with its regulator that will cap its balance sheet at the level reached at the end of 2005. Therefore, no further net issuance from Fannie should be expected, at least for the foreseeable future. Freddie faces a similar threat, but as yet, no restrictions on its growth are in place. The other major agency, Federal Home Loan Banks, has been growing rapidly along with the private-sector issuers and it may continue to do so.
As long as private-sector ABS issuance remains heavy, there is no reason to expect a revival of the conundrum. This could change later in the year if the slowdown in the US property market results in much less mortgage origination than analysts are currently forecasting. For now, however, there seems to be no further reason for bond yields to decline from a flow of funds perspective. If yields do fall, it will be because the market has begun to expect a significant economic slowdown, rather than due to factors related to supply and demand for debt.
Your watching the conundrum analyst,