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In the chart below (source: Bloomberg) I show the changes in the
(on-the-run) Treasury yield curve, since June 19th. I wanted to
visualize these changes since the retrenchment in equities and credit
(which started last week) began. The most notable change is in the 7
and 10-year issues, which have appreciated (yield decreased)
substantially. I find it interesting, very telling, to see that both
the short-end and long-end of this curve have not followed the strong
appreciation. This may signal caution, the lack of a strong view from
the market on where and how the situation is unfolding. Should Q2
earnings surprise on the upside, the short end of the curve would
depreciate quickly, driven by the return to a risk friendly mood.
Consistently, given the ongoing monetization of deficits, a risk
friendly environment would only be the other side of asset inflation,
bringing inflation expectations back on stage (together with mortgage
convexity hedging) and driving the long-term yield back again towards
5% (In the meantime, the reverse process in the mortgage world is
taking place).
As Q2 earnings are released, the present danger, therefore, is new,
lower lows in equities. This time, disappointing earnings would signal
a weak consumer (finally higher savings rate) that may or not trigger
more violent defaults, and hence loan losses. In our Thursday letter
(www.sibileau.com/martin/2009/07/09/ ) I suggested that although the
retrenchment is based on endogenous factors, there were still relevant
exogenous ones to keep in mind.
Given the steady decrease in Libor, the narrowing of swap spreads
and the shape of the yield curve, I am now more inclined to believe
that lower lows can only take place as a result of exogenous/political
events. It is a confusing notion, because the problems affecting the
world have not changed; they have merely been transferred from the
previously free, unregulated, marked-to-market balance sheet of the private sector to the political, regulated, amortizing balance sheet of the government.
There are only two possible outcomes, not mutually exclusive, from
this situation: A crowding-out effect (that would do justice to David
Ricardo) or an inflationary process (that would give posthumous fame to
Keynes). Right now, the market is precisely gauging the balance between
the two. When the Fed doesn’t insinuate further action, the market
remembers Ricardo. When the Fed does insinuate it, the market remembers
Keynes. To me, the key here is to remind ourselves that Mr. Obama will
understandably seek reelection, which is years away. Inflation (Keynes)
will be delayed, leaving more chances for the crowding-out effect. In
the times of Ancient Rome, the Senate avoided the crowding-out effect
by sending troops to conquer new countries, confiscating the wheat
harvests of Egypt, the source of savings of the Ancient World. In 2009,
China can certainly not be accounted for something of the sort.
Therefore, the S&P500 could still go lower!
US Treasury yield curve (on the run issues): From June 19th 2009 (green) to July 10th, 2009 (white) (Source: Bloomberg)
