Wake up & smell the coffee! China goes short duration

When the largest investor in any asset aggressively reduces their exposure, it's time to reassess that investment.

With holdings of $744.2 billion, China is the largest foreign holder of US Treasuries. This amounts to 24% of foreign holdings.

However, in a recent research note, Standard Chartered note that:

"Although bulk buying of Treasuries has ended, China is not reducing its stock of US securities. It is reducing its holdings of agencies and maintaining growth in its holdings of Treasuries, but is switching from long-term to short-term securities (tenors of less than one year)... holdings of short-term Treasuries surged to USD 182bn in February 2009 from USD 19.87bn in September 2008."

In portfolio management terms, this equates to an aggressive short duration position - standard practice if you expect yields to rise. Perhaps the scale of this positioning (25% of their holdings in sub 1 year paper) is a measure of how much they expect yields to rise. Indeed, Chinese officials have recently been vocal about their concerns regarding Treasuries and the US Dollar.

Could this mark the reversal in the 20 year bull market for Treasuries? Dr. Marc Faber certainly thinks so...

"The asset market that has the highest probability of having a made a secular high (such as Japan in 1989, or the NASDAQ in March 2000) is the U.S. long-term government bond market. Despite a still-weakening economy and massive quantitative easing, long-term bond yields appear to be on the verge of breaking out on the upside."

When in trouble, double!

Since the initial announcement and subsequent implementation of QE, Gilt yields have steadily risen (see above chart). Mervyn King has therefore lost money on his £52 billion of Gilt purchases. So, like any punter would do when faced with a loss, big Merv has doubled up.

At today's rate announcement, the Bank of England revealed that it will increase its existing QE facility by an additional £50 billion:

"The Committee also agreed to continue with its programme of purchases of government and corporate debt financed by the issuance of central bank reserves and to increase its size by £50 billion to a total of £125 billion. The Committee expected that it would take another three months to complete that programme, and it will keep the scale of the programme under review."

The 10 year Gilt yield fell 10 basis points. Could this be an inflection point in the 75+ basis point rise in Gilt yields?

Reassessing Gilts: don't panic Mr Mainwaring!

In light of the 30-35 basis point back-up in the 10 year Gilt yield, pushing it above 3.5%, it is time to reassess the investment case for Gilts.

A tumultuous week for Gilts started with Alastair Darling's pre-budget speech, in which he announced the Government will borrow £220 billion this fiscal year, increasing the public debt:GDP ratio from 45% to 76.2% by 2013. This was followed by a Moody's report, How safe are safe havens?, which sent yields higher and Sterling lower, on concerns over the UK's credit rating. Finally, Q1 UK GDP came in worse than expected at -4.1% year-on-year, the worst since 1979.

So, which, if any, of these facts warrant higher Gilts yields?

Increased Gilt issuance

Economic s 1.01 says that, increased supply of a good results in a lower price unless there is a similar rise in demand. However, as the chart below demonstrates, there is little or no relationship between Gilt issuance and Gilt returns. Indeed, the 2008/ 09 financial year saw record gross Gilt issuance of £146.4 billion and the third highest Gilt 12 month total return of 6.8%.

Further proof that bond issuance and returns are not related comes from Japan, where a sustained increase in public debt has been accompanied with a fall in JGB yields.

Moreover, the supply-demand dynamic has shifted in favour of Gilts due the Bank of England's QE programme. The full £100 billion authorised by HMT for Gilt purchases represents 18% of the overall £543.9 billion Gilt market and 45% of the gross issuance this financial year.

These percentages are not small. Indeed, at the end of Q1 2009, the Bank of England had 'only' spent £12.9 billion on Gilts, out of a possible £75 billion. Mervyn King has plenty of firepower left at his disposal with which to mop up new issuance and force yields lower. Thus, to some extent, what the Chancellor giveth, the Bank of England taketh away.

Moody's report
Next, the Moody's report. For all the hysteria it generated, the essence of the report was not as bearish as the market reaction. The conclusion is summarised below:

"Moody's believes that Aaa governments' unconventional policies are defensive responses that are – at best – ratings-neutral if they succeed in kick-starting economic activity. However, if they lead to massive increases in public net debt and a permanent deterioration of debt affordability without tangible growth effects, Moody's cautions that they will be ratings-negative. In extremis, since confidence is not a linear process, these policies could potentially increase 'tail risk', and therefore also the (currently small) risk of sharp rating migration."

Indeed, a spokesman for Moody's confirmed, "the [UK] rating has not changed, and it's not under review for a downgrade. The outlook is stable."

UK GDP

GDP and Gilt returns have a negative correlation, meaning that as GDP falls Gilt returns increase. The chart below demonstrates this by comparing year on year GDP against the 12 month total returns of Gilts.

So, why then was worse than expected GDP cited as a negative for Gilts? The answer could lie in the relative position of the UK versus other developed nations. IMF forecasts for developed nations' GDP are as follows:

The economic outlook for the UK may not be good, but it is no worse than in others countries, indeed, with the exception of the US, it is the best of a bad bunch.

Conclusion

Therefore, it appears that, on balance, nothing has changed the medium term term outlook for Gilts. Yes, inflation is a risk for the longer term, but as the above evidence suggests, none of the developments last week appear to warrant higher Gilt yields.

So, in the immortal words of Corporal Jones, "don't panic Mr Mainwaring!".

Why QE will push Gilt yields lower

The fat lady hasn't sung yet and the Old Lady of Threadneedle Street can go on buying Gilts indefinitely until it has the desired effect...

http://www.bondvigilantes.co.uk/blog/2009/04/02/1238686980000.html

UK CPI: one swallow doesn't make a summer

UK CPI (February YoY) came in ahead of expectations at +3.2% versus consensus of +2.6%. The 10 year Gilt yield rose to 3.37%, up 24 basis points. Mervyn King commented this morning on the higher than expected inflation number in an open letter to the Chancellor:

"Since last summer, world commodity prices have fallen sharply and that has helped drive a fall in overall CPI inflation from 5.2% in September to 3.2% in February. But the effect on UK consumer prices of decreases in world prices has been dampened by the depreciation of sterling. Since my December letter, the sterling effective exchange rate has depreciated by about 5%, bringing the total depreciation to 28% since the summer of 2007. February's inflation out turn is somewhat higher than expected. That could reflect pass-through of the exchange rate depreciation to consumer prices since much of the strength in the out turn appears to be concentrated in components where a large share of goods is imported."

Later, when questioned by the Treasury Committee about the implications about the implications for the Bank's QE programme, Mervyn King commented:

"We might need to do less on QE than £75 billion if it works... the target is to complete something in the order of £75 billion in QE over the next three months"

However, one swallow doesn't make a summer and it is still premature to say whether monetary policy is working or if it is stoking inflation. Indeed, Mervyn King noted in a statement to the Treasury Committee this morning that inflation is likely to fall in the medium term:

"Inflation in the UK is currently still above target. CPI data released this morning show that inflation was 3.2% in February, triggering another open letter from me to the Chancellor. At its next meeting, the Committee will want to consider further the implications of this inflation out turn. But the sharp slowdown in spending is likely to generate a significant margin of spare capacity in the economy, which, in turn, will bear down on inflation in the medium term. So the key question for the MPC is how to ensure nominal demand returns to a level that is consistent with meeting the inflation target."

Anything you can do...

Anything you can do,
I can do better.
I can do anything
Better than you.

No, you can't.
Yes, I can. No, you can't.
Yes, I can. No, you can't.
Yes, I can,
Yes, I can!

Following the Bank of England's recent announcement that it intends to purchase £75 billion of Gilts, the Fed announced today it will purchase up to $300 billion of long dated Treasuries over the next six months. Beat that Mervyn!

Despite being a drop in the ocean (c. 2.7%) relative to the $11 trillion of outstanding public debt, $300 billion was enough to push yields down significantly. Longer dated Treasuries surged on the news, with 10 year yields falling 47 basis points to 2.54% and 30 year yields fell 37 basis points to 3.46%. The 10/2's spread flattened 37 basis points 1.62%.

However, the move stoked fears of inflation and currency debasement, pushing gold 6% higher. Bloomberg reported that:

The dollar fell the most against the euro since September 2000 as the Federal Reserve said it will purchase $300 billion of longer-term Treasuries, spurring speculation the central bank is debasing the currency. The dollar depreciated as much as 3.3 percent to $1.3493 per euro before trading at $1.3468 at 3:20 p.m. in New York. The dollar lost 2.5 percent to 96.17 yen from 98.60. The yen dropped 1.1 percent to 129.44 per euro from 128.35. The Dollar Index, which the ICE uses to track the greenback’s performance against the euro, yen, pound, Canadian dollar, Swiss franc and Swedish krona, dropped 2.7 percent to 84.595. The gauge fell 5.6 percent since reaching 89.624 on March 4, the highest level since April 2006.

Quantitative easing is now de rigueur amongst the world's major central banks. The Bank of England is buying government bonds and corporate debt, the Bank of Japan is snapping up government notes and making subordinated loans to banks, and the Swiss National Bank is intervening to weaken the franc. Naturally, anything the rest of the world can do, America can do it bigger and better...

QE gets under way

UBS Investment Bank reports:

"The Bank of England embarks on its quantitative easinig effort today with a £2 billion gilt purchase. This will the first of a bi-weekly event that will continue for the next 3 months until the Bank has acquired around £75 billion of gilts and corporate bonds."

Purchases will be made via a reverse auction, in which sellers determine the price that the BoE pays. The Bank will hold only one auction this week, but there will be two per week from next week on Mondays and Wednesdays. The central bank will take non-competitive offers until 12:00 p.m. on auction days, announcing the amount it will allot to such offers at 1:00 p.m.. It will then also publish the size open to competitive offers, and will take bids for that operation between 2:15 p.m. and 2:45 p.m. British time. It will announce the results of that operation soon thereafter.

In today's auction the BoE has specified it wants to buy £2 billion of Gilts maturing from 2014 to 2018. M&G's bond team note, via their blog, Bond Vigilantes:

"The Bank is not buying back sub 5 year paper as part of this programme, as that is where overseas Central Banks (big financers of the UK budget deficit) own gilts, and it could lead to a big reduction in the gilt market's investor base and a possible knock on impact on the £ if overeas investors sold their gilts back to the authorities. Nor is the Bank buying gilts over 25 years in maturity, which would exacerbate the illiquidity in ultra long dated gilts, and possibly cause further problems for pension funds."

Auction results
The reverse auction was 5.25 times subscribed as the BoE receioved offers of £10.5 billion and bought £2 billion. Bull flattening is under way, with the UK 10-2 spread having tightened by 50 bps since the BoE first announced QE on Thursday.

QE in the UK

A new era of monetary policy was ushered in yesterday as the Bank of England embarked on quantitative easing (QE). In the press release that accompanied yesterday's 50 basis point rate cut, the Bank of England confirmed the size and implementation of its quantitative easing programme.

Having received approval from the Chancellor to begin quantitative easing, the MPC voted to begin a programme of asset purchases of £75 billion over three months via the Asset Purchase Facility. This represents the first tranche of an overall £150 billion sanctioned by the Treasury for purchasing of £50 billion of private sector assets (CP & corporate bonds) and up to £100 billion of Gilts, as requested by Mervyn King in recent letter to Chancellor:

"In order to facilitate an expansion of the monetary base through the Asset Purchase Facility, the MPC proposes that gilt-edged securities be added to the list of eligible assets set out in your letter of 29 January. I suggest that the MPC be authorised to use the facility to purchase eligible assets financed by central bank money up to a maximum of £150 billion but that, in line with the current arrangements and in recognition of the importance of supporting the flow of corporate credit, up to, £50 billion of that should be used to purchase private sector assets… If the facility were to be used for monetary policy purposes, I envisage that the Committee would vote each month on a resolution concerning the asset purchases it deemed necessary to meet the inflation target."

What are the implications for the Gilt market? More specifically, which part of the Gilt curve will be impacted most and how does the size of the programme compare to the value of outstanding Gilts?

In their press release, the Bank of England indicated that the majority of the first £75 billion will used to buy Gilts. Purchases will target medium (7-15 year maturities) and long (15+ year maturities) conventional Gilts, as defined by the Debt Management Office (DMO).

The nominal value of all outstanding conventional Gilts is £543.9 billion. The market is segmented between £233.7 billion (43%) in short Gilts, £107 billion (20%) and £203.2 billion (37%) in long Gilts. The first tranche of £75 billion therefore represents 24% of the universe of eligible Gilts of £310.2 billion. The full £100 billion sanctioned for Gilt purchases represents 32% of medium & long Gilts and 18% of the overall Gilt market.

The size of the initial tranche of £75 billion is also substantial in relation to forthcoming net Gilt issuance, representing 58% of the £130 billion expected in the current financial year. Furthermore, the chancellor confirmed that current debt management policy remains in place and there are no plans to change it in light of quantitative easing.

The size of Bank's quantitative easing programme is therefore significant and will have a sizeable impact on the Gilt market. Indeed, the initial 40 basis point rally in 7 to 30 year Gilts following the announcement reinforces this. Going forward, it is likely therefore that the Bank of England's operations will result in a bull flattening of the Gilt curve, as long yields converge on shorter yields. Bull flattening is not only consistent with the Japanese experience of QE in the 1990's, but it has become the consensus forecast for the Gilt curve, as the chart below demonstrates.

Gilts: bank liquidity + QE = bull flattening

Two recent developments imply bull flattening of the Gilt curve...

First, Morgan Stanley estimate that UK banks will be forced to buy up to £100 billion of Gilts in 2009, following the announcement of FSA’s new liquidity regime . This compares to a total Gilt market size of about £480 billion as at end-2008, and planned net Gilt issuance this financial year of about £130 billion.

Banks will be required to hold Liquid Asset Buffer portfolios, consisting of a combination of Gilt holdings stretching far out along the yield curve, with perhaps some of the duration risk hedged by interest rate swaps. Moreover, the steep Gilt curve gives a strong incentive to put more long-dated Gilts in the portfolio, despite their higher volatility.

Second, the MPC unanimously voted to seek authority to embark on quantitative easing (see February MPC minutes) in the form of buying government and other securities, financed by the creation of central bank money using the Asset Purchase Facility. The BoE believes that these measures are required in order to prevent CPI undershooting it's 2% target until 2012. The size of this QE program is rumoured to be £100-150 billion.

Both these developments imply bull flattening as a possible £250 billion of Gilts are purchased, forcing a compression in longer dated yields. Moreover, this is more than enough to soak up all of the expected £130 billion issuance for the current financial year.

Some links to articles demonstrating the above:

http://ftalphaville.ft.com/longroom/tables/fixed-income/gilts-bank-liquidity-qe-and-bull-flattening/

Government Bonds: Bulls vs. Bears

Bullish: Falling interest rates, deflation, quantitative easing (QE), flight to safety = bullish flattening for yield curves (see Japan below)

BoE Jan minutes show MPC unanimously agreed that Mervyn King, governor, should seek authority for purchases of gilts and other securities in an effort to broaden the money supply. The Bank of England believes that inflation will undershoot the target until 2012 unless it engages in quantitative easing. Implementation rumoured £10-15bn over next 3 months.

Barcap revised Bank of England rate view & expect Bank rate to be cut by 50bp at the March meeting to 0.50% then leave policy rates unchanged as it embarks on a programme of QE. Barcap no longer expect a back-up in gilt yields (forecast bottom @ 3.25% Q3 '09 vs. Bloomberg consensus 3.13%) in the second half of 2010. Barcap expect any tightening cycle commencing in 2011 to be relatively cautious.

China held $696bn of US Treasuries in Dec 08. Luo Ping, a director-general at the China Banking Regulatory Commission, said that China would continue to buy Treasuries in spite of its misgivings about US finances: “Except for US Treasuries, what can you hold?” he asked. “Gold? You don’t hold Japanese government bonds or UK bonds. US Treasuries are the safe haven. For everyone, including China, it is the only option… We hate you guys. Once you start issuing $1 trillion-$2 trillion… we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.”

Bearish: Risk premiums very low – return-free risk – don't adequately compensate investors for risks: CPI & record issuance. Turning a blind eye to fundamentals or risk, is a good indicator of a bubble.

Increased issuance will put pressure on FX & yields (e.g. US 10yr +1% YTD on record issuance announcement). However, a degree of inflation is beneficial, since it will reduce the debt burden
In recent years, demand for US government debt has been stoked by developing countries running huge trade surpluses with the US and recycling dollars by buying Treasuries. However, many are facing growing pressure to stimulate their own economies and are seeing their current account surpluses decline as global demand diminishes.

Index linked markets attractive (despite recent rally in BEIs) as only LT risk free asset. Whilst deleveraging in the short term ≠ CPI. However, the further interest rates fall in the short term, the greater the risk of inflation in the medium to long term. Thus, at some point, assuming the stimulus has the desired effect of reflating the economy, inflation will rise again, possibly in an aggressive manner. Moreover, given that the stimulus is funded by record amounts of government borrowing, yields are likely to respond in kind to both rising inflation and issuance as investors demand a higher risk premium. Indeed, it is possible that governments and central banks may wish to induce a period of above target inflation in order to reduce the public and private debt burden.

UK 10yr BEI 2.1% = just over BoE CPI target & risk to upside.