Wednesday, October 8, 2008

The Bond Market Awakens!

Good evening everyone.

What a crazy day. The bears and the bulls duked it out until the close. The bears won the fight by knockout in the last round.

I don't want to talk about the stocks tonight folks. Something terrifying happened today in the credit markets, and I don't think I am going to sleep well tonight. There was a major event in the bond market today.

This is complicated, but I will try to simplify it for everyone. I have often warned of a potential bond market dislocation if the government continued to spend like drunken sailor. It appears that as of today, the bond market finally woke up and told the government "enough already!".

The chart on the 10-year says it all:

Here is the news from Bloomberg:

"Oct. 8 (Bloomberg) -- U.S. bonds fell after the Treasury Department sold $66 billion in debt to ease ``severe dislocations'' prompted by shortages of government securities amid the turmoil in global financial markets.

Two-year note yields climbed from seven-month lows after the Treasury's emergency reopening of $20 billion in 10-year notes in two auctions. It also sold $40 billion in so-called cash management bills and $6 billion in inflation-indexed debt. Failures to deliver or receive Treasuries in the $7 trillion-a- day market for borrowing and lending securities surged to a record in the week ended Sept. 24 as investors sought the safety of U.S. government debt.

Treasury sold $20 billion in 10-year notes in emergency auctions and will issue another $20 billion in the notes tomorrow. Today's initial sale of debt maturing May 2015 yielded 3.31 percent, 40 basis points higher than the yield on the outstanding security originally issued in May 2005. The other sales also drew higher yields than they would have had the notes sold at the pre-auction market price.

Costly Auctions

Because of those differences, which are known to traders as tails, the government lost $345 million in potential proceeds, according to an analysis by Credit Suisse Securities USA LLC. Strategists and investors said the government received lower prices because it rushed to market.

``We didn't have a lot of warning,'' said Jay Mueller, who manages about $3 billion of bonds at Wells Fargo Capital Management in Milwaukee. ``I understand what they were trying to do -- those bonds have been in short supply to deliver and have been failing in repo so they wanted to boost the supply. It was a nice idea in theory but in practice it didn't go off too well.''

My Take:

Alright lets try to put this story together. The government basically "out of the blue" decided to sell treasuries via an "emergency" auction. The Fed explained that this was done because there was not enough supply of treasuries to satisfy demand the week of Sept. 24th according to their data.

How can I say this? Uhhh, the auction didn't go so well. When the treasuries went up for sale, the government was forced to raise the yields 40 basis points in order to complete the sale. Folks, This 40 point "tail" is massive. One trader explained that this is one of the highest tails they have ever seen.

Now I have a question: If this auction was done in order to satisfy the demand from a week ago, why did they have to "bend over" and raise yields to the moon in a crashing market in order to get the paper sold? I don't buy it and either do the bond traders.

Many bond traders believe this auction was done because the Fed is running short of cash as they continue to drop money out of helicopters via the bailout and TAF funds. There is also the belief that this money will be used by the Fed to loosen up the commercial paper market which is now locked as banks continue to refuse to lend to one another.

The fact that yields had to rise on order to sell the paper is an eye opener. Usually there are plenty of buyers for treasuries in a falling market. This is why the yields on treasuries always drop when you see a big dump in the stock market. The fact that yields had to go through the roof in order to sell the emergency paper tells you that there was very little demand for the paper.

Now yields themsleves are still low, but what you need to focus on is the fact that yields had to RISE sharply in order to sell treasuries on a day where yields should have been DROPPING as investors flew to the safety of treasuries. The appetite for treasuries should have been very strong today. The fact that there was no demand is troubling.

If yields go through the roof via a buyers strike, the housing market is TOAST. You can't borrow much money to buy a house if interest rates are at 10%!

The CNBC Spin

Bubblevision(CNBC) and the pigmen reported today that this rise in yield was a "good" sign. Their spin is that this rise in yield was a positive because it tells you that investors are getting out of the safety of treasuries and are placing money back into the credit markets. They concluded that this willingness to take "risk" should be seen as a bullish sign for the markets.

This is the biggest load of crap I have ever heard. The bottom line is the government had no demand for the paper.

Lets say CNBC was right and everyone was ready to pour out of treasuries and fly back into the commercial paper market? We still would be screwed because there would then be no buyers for treasuries because their money would all be in the commercial markets. So ask yourself this question: How high would treasuries have to be priced then in order to sell it if everyone flocked to the commercial paper market to celebrate the new bull market? 6%? 8%?

That would work out just dandy for the housing market wouldn't it? NOT! CNBC's bullish scenario would basically destroy the housing market because mortgage rates would go through the roof due to the higher yields on treasuries.

Bottom Line

This was a startling development today. This could signal that a bond market dislocation could be days away. My hedging shorts are going back up tomorrow based on this news. I initially thought the volatility we saw today was a sign of searching for a temporary bottom that would produce a bounce.

The fact that the bond market dissed the Fed has completely changed my short term thesis. Remember folks, if we can't sell treasuries, we can't finance our debt and the game is over!

There are many theories as to why the bond market finally woke up and lowered their appetite for treasuries. Many foreign countries are financially imploding right now. The Nikkei dropped 9% last night. Perhaps foreign countries have decided it might be better to keep their money at home to fight an internal collapse versus tying up their capital up in our treasuries.

Also, perhaps foreign countries have no desire to buy our treasuries now that they will be getting back cash via the TARP(housing bailout) for all of the subprime sandwiches they were suckered into buying.

There are many reasons why the auction had a lack of buyers today forcing yields to rise. I think its a combination of all of these factors. The massive government spending is the biggest issue IMO.

I have said it before. The bond market is almost never wrong and almost always gets its way. They sent a strong signal to the government today. STOP SPENDING or else!

Lets see how Hank and Ben react to their strong message. If they continue to ignore them and keep selling treasuries, we could have 10% mortgage rates sooner than you think. The bond vigilantes did the same thing when Clinton tried to spend like a drunken sailor in the early 90's. The government backed off and spending packages like national healthcare disappeared.

Pay close attention to the bond market. If the government is forced to reign in spending, the bailouts and the liquidity will for the most part be gone. If this happens, the economy goes down the drain and so does the housing market.

The only thing left would be a nasty consumer led recession or worse.


Avl Guy said...

Hey jeff, good post!
The rest of my comment got lost somehow.

Anonymous said...

Are you short or still mainly in cash? Thanks.

Anonymous said...

So, what does this mean if you hold bond funds such as SHY and IEF?

Jeff said...



Today was an eye opener for sure.

The fed is now saying they might take an ownership in the banks.

Can you say insolvency! If this creates transparency it would be a good thing.

If they continue the smoke and mirror games with the losses, this will do nothing to fix the problem.

Jeff said...

anon 1

I am still 80% in cash. I hate to short the hole here after 5 down days.

I will add some short positions tomorrow for protection.

I am taking these positions to protect myself as an investor not as a trader. We may rally tomorrow after the massive losses this week.

A massive bounce here would not be surprising.

BUT, if the bond market collapses, we have a long ways to go on the downside.

Hedge your risk! If your shorts lose money and you have long positions, you don't get killed.

Jeff said...

anon 2

(SHY) shuld be ok. I would get out of IEF because it involves the 10-year.

If you want a nice hedge on treasuries, buy some puts on (TLT),

This is a short on long term treasuries. SHY should be ok because its composed of short term treasuries.


growler said...


I'm surprised you are surprised. You have mentioned this possibility in the past before.

IMO, we will not see a bounce / rip until the TED spread and CP market resumes functionality (however minimal that may be). I suspect the market is now saying without credit (the oxygen or our econ) we ain't buying. Period.

Jeff said...


I am surprised at the speed at which this is all happening.

I totally agree with you on the credit market lockup.

I don't know what the Fed can do to get it kickstarted again. This is just stunning!

GM might be bust! I am really getting nervous. This is getting dangerous.

ZMonet said...

I fully agree with you Jeff and was just telling someone today that while I saw this coming, I didn't realize it was going to happen so violently. The question is whether the fall is happening "so fast" or whether we are just going to go way down.

I don't know about others out there, but it is a little strange seeing all this break out. It is kind of like drinking poison (which I'm not suggesting anyone do). You know that you are going to get sick, but immediately after you are doing fine. My point is that most people on the street just don't stop spending no matter if the DOW goes up or down 5000 points. You literally have to take the credit and money out of their hands. I guess we're finally at the point where the consumer has no other options for spending. Even that craziness of getting an ATM card against your 401(k) -- well, your 401(k) is running out of money too!