Cognitive Dissonance in the Markets?

Even though the US Treasury market has taken a nasty downward move through an important level that many participants see as the beginning of a bear market in bonds (which will inevitably lead to a bear market in equities), actors in other sectors of the financial markets seem remarkably sanguine, at least so far. Is this denial, or does the market have one last hurrah before the turn is irrevocable?

Tony Jackson of the Financial Times muses about the crosscurrents in his article, “Tolerance of risk seems high in spite of bond scare“:

Now that the dust has settled from last week’s scare in the bond markets, a slightly unexpected consensus seems to be emerging. There is nothing to worry about, we are told. In fact, this is all good news. Treasury yields are rising because US growth prospects have improved. So unlike the February wobble – when US weakness was the story – there has been very little flight from risk.

I find this a bit of a stretch, but it certainly bears examination. To begin with, it seems clear that the rise in Treasury yields is to do with higher real yields, not inflation worries. It is also true that there has been no real re-pricing of risk.

The independent firm Absolute Strategy Research runs what it calls its Spook index, which combines eight different measures of investor nervousness. It rose slightly last week, but not as much as in February – and nothing like as much as last spring, when emerging markets hit a bad patch.

It is also striking that while government bond yields have risen, spreads on corporates – at the investment grade end, anyway – have scarcely moved. As for credit derivatives, the spread on the European index – that is, the cost of insuring against default – was at an all-time low a week ago. It has since risen slightly – but again, by much less than in February.

So far, so rosy. Now, two questions. Is it clear why real yields are rising? And are we quite sure this is good – or even neutral – for other asset classes such as equities?

On the first point, there has been good news on the US economy in recent weeks, including the recent payroll figures. But there is an alternative explanation – simply that real yields, having been anomalously and puzzlingly low for a couple of years, are moving back towards normal.

What might prompt that is hard to say. But if it were to reflect a slackening appetite for US Treasuries among Asian central banks, the US growth story would be rather harder to sustain.

As to whether equities should be immune from all this, there are several factors to bear in mind. On the one hand, rising bond yields act as an automatic brake on demand, and also present highly leveraged corporations with higher finance costs.

That apart, the whole mergers and acquisitions boom – and the associated boom in private equity – has been based on a carry trade between the cost of money and the cash flow yield on equity. At some point, the two will cross over – as they already have in the commercial property market, with rents now lower than the cost of finance.

Doubtless, we are not there yet. But one place to look for danger signals will be the market for leveraged loans. The banks will keep on issuing those as long as they are confident of passing them on. As soon as they discern a real risk of being left holding the bag – a danger which has been exercising central banks lately – they will pull in their horns.

At the same time, expect an extra frenzy of press reports about forthcoming bids. Investment bankers can read the signs better than most, and will be the more desperate to get deals away before the bar comes down. And when that happens, we will find out just how big the M&A premium is in today’s markets.

Meanwhile, one curious straw in the wind. In recent days, according to weekend press reports, several UK companies are looking to take advantage of the rise in bond yields to offload their pension funds to those financial firms which have lately been set up to take them off their hands.

The reasoning is simple. Because bond prices have fallen more than equities, liabilities have fallen by more than assets, and deficits have narrowed. So this provides a window for sponsors to get out before equities fall in earnest.

Of course, they may be quite wrong in expecting anything of the sort. But on balance, my sympathies lie with them.

Tolerance of risk across the markets still seems abnormally high. It is in that context, surely, the bullish case must be placed. It takes a special frame of mind to see a surge in bond yields as a buy signal. Investor psychology, like anything else in the markets, tends to revert to the mean. When that happens, watch out.

The disconnect continues with the leading story on the FT website, “Bonds plunge as US debt loses its appeal“:

Government bonds around the world plunged again on Tuesday, bringing 10-year US Treasury yields to their highest levels in more than five years amid signs that the foreign appetite for US government debt could be ebbing.

The continuation of last week’s sell-off could push mortgage rates higher, further weakening the battered US housing market. Countrywide, the largest US mortgage lender, said on Tuesday that its foreclosure rated doubled in the year to May.

The upward trend in government bond yields is also set to make corporate borrowing more expensive, potentially undermining the easy credit conditions that have been supporting the global buyout boom.

European bond yields also set new multi-year highs, with the the 10-year Bund yield rising almost 6 basis points to 4.61 per cent. Stocks fell, with the S&P 500 index closing down 1.1 per cent and the FTSE Eurofirst 300 index retreating 0.5 per cent. The yield on 10-year US Treasuries rose to a high of 5.27 per cent, its highest level since May 2002, before settling back to 5.26 per cent in later trading, up 12bp for the day.

It marked the first time the benchmark yield has been above the prevailing Fed funds rate of 5.25 per cent since the US central bank tightened overnight lending to that level in June 2006.

The session’s peak yields followed a weak $8bn sale of new US 10-year bonds, in which foreign investors bought less than 11 per cent of the bonds available.

Dominic Konstam, head of interest rate strategy at Credit Suisse. ”Foreign investors are not buying this market and Treasuries are also having to compete with higher returns on risky assets.”

Analysts say foreign buying – for example by the Chinese central bank – has been holding Treasury yields down in recent years. But China’s announced investment in Blackstone, the private equity firm, and other signs of interest in other types of investment suggest foreign governments are starting to diversify their holdings.

Indicators of corporate credit risk – such as the European iTraxx crossover index of volatile credit derivative names – have risen slightly, but are yet to reflect signs of serious concern.

Kingman Penniman of KDP Investment Advisers, a US high-yield consultancy, said 5.25 per cent yields were psychologically significant and investors were still wondering if they would hold above that level. If so, he said, “At some point we will be repricing risk in a meaningful way, but that hasn’t happened yet.”

In an interview following Lehman Brothers’ earnings report on Tuesday, Chris O’Meara, the investment bank’s chief financial officer, said: ”So far it’s been an orderly back up in rates. The thing nobody wants to see is a shock of some sort. Right now I don’t think it’s going to change anybody’s mind about doing a deal.”

If rates continue to rise, he said it could begin to have an impact on the deal-making landscape, which has been shaped by the availability of cheap finance. He said strategic buyers could begin to gain an advantage over private equity firms.

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