With so many focused on appeasing markets with fiscal austerity measures, an interesting dynamic is taking shape.
The word out of the G-20 summit this weekend was quite the contrast from a year ago. Previously the G-20 expressed a commitment to maintaining fiscal stimulus in order to provide a boost to the slumping global economy. This year however, the European nations came into the summit on the heels of initiating their own aggressive austerity measures while pushing their developed world peers for more of the same.
Many in the US assert that cutting the deficit is necessary because sovereign debt markets are becoming increasingly concerned about levels of fiscal indebtedness as a percentage of GDP. Treasury yields had been particularly low to begin with and it seems as though the austerity discussion actually has led to yet lower Treasury yields (TLT), and not for the right reasons.
The way I see it, there are two primary factors behind the recent rally in Treasuries and I’ll visit each in turn:
With correlation strikingly high to the downside, asset classes of all shades are experiencing pain. European sovereign debt woes started the flight into safety with Treasuries rallying through much of April and exploding higher in the midst of the Flash Crash in early May. Since then the trend has not stopped. There is no market more liquid and safe than the Treasury market (safe despite sovereign debt woes!) and in many respects, this is a move not based on pure valuation, but rather on relativity and emotion.
When people sell assets they need somewhere to park their money. Why deposit that cash in an uninsured account with an institution whose credit default swaps may unknowingly spike through the roof at any moment when one can merely lend it to the US government, collect a small yield and be assured of its safety? Why buy European sovereign debt, when relatively speaking the US is far safer and has the political capacity to print money should things get really out of hand? No matter which angle you take, US Treasuries are as safe an asset as one can find.
2. “…Extended Period…”
The Fed Fund Futures have consistently been behind the ball in gauging when the Federal Reserve Bank would begin its escape plan from the expansionary monetary policy initiated during the throes of the financial crisis. The Fed Fund Futures are now repricing that time frame. As governments continue contemplating austerity measures, it is becoming increasingly clear that monetary policy is the only tool left at the disposal of policymakers in order to counteract the affects of more economic weakness. Moreover, the pervasive weakness across all asset classes of late leaves little choice for the Fed but to remain aggressive with its interest rate policy, while weening off its creative and novel measures (such as open market purchases of mortgage backed securities, which ended in March).
It should now be clear to just about everyone that the Fed will not seriously consider raising interest rates, let alone striking the “extended period” language from FOMC statements in the near future. After all, Fed Chairman Ben Bernanke has consistently expressed over time the value of Fed communications in effecting policy and with interest rates already at the zero bound, communication is a VERY important tool. In a speech in Japan in 2004, Bernanke said the following, which provides a great clue as to the direction of monetary policy (substitute “extended period” for “considerable period” and it is strikingly similar to what one would expect to hear in 2010):
Most recently, the Committee has introduced additional commentary on the outlook for policy into its statement. For example, the August 2003 statement of the FOMC indicated that “policy accommodation can be maintained for a considerable period,” a formulation replaced a few meetings later with the comment that the Committee could be “patient” in removing policy accommodation. These statements conveyed information to markets about the Committee’s economic outlook as well as its policy approach. In my view, this language served an important purpose, illustrating in the process the value of central bank communication. At the time that “considerable period” was introduced, the market was pricing in a significant degree of near-term policy tightening, presumably on the expectation that the sharp pickup in growth in the third quarter of 2003 would induce the FOMC to raise rates. [emphasis added]
What this all means:
As Brandon said today, we must ask whether “austerity is restoring confidence, or killing the patient?” While Treasury yields have declined in response to the austerity talk, there is a disconnect between cause and effect. Treasuries seem to be declining far more because of trouble in other asset classes than they do in response to the seeming conviction of G-20 countries to embark on a deficit cutting mission. Clearly, equity markets are under a great deal of stress right now. Austerity does not necessarily lead to the desired, and what some would call common sense outcome. There is extreme risk in undertaking these measures too soon and too aggressively. I will conclude with a quote from Bill Gross (yes, I used this same quote within the past week, but it is that right on):
“Tougher sovereign budgets produce government worker layoffs, pay cuts, reduced pension benefits and a drag on consumption and the ability of the private sector to accept an attempted hand-off from fiscal authorities. Recession becomes the fait accompli, and the deficit/GDP ratio moves ever higher because of skyrocketing risk premiums and a plunging GDP denominator. In many cases therefore, it may not be possible for a country to escape a debt crisis by reducing deficits!” [emphasis Gross’]
This “drag on consumption” is being priced into equities with the pervasive weakness being led by the financial sector and any sector with exposure to consumers, particularly retail.