Convergence Under the Bed Spread

Strategic Investment’s Daniel Denning (our very own green-saronged analyst!) explores the possibility of a falling credit rating for US government debt — banana republic style!

Illusions often die a sudden and not-so respectable death.

The other day on the Paris Metro, an overweight, middle aged woman took to the center of the car and muttered under her breath repeatedly "Pere Noel est Morte." Santa Claus is dead.

While this was not news to me (nor was it exactly true, in the sense that Santa Claus doesn’t really exist), it was quite shocking to the handful of children within ear shot. A crash in the Santa index ensued.

Such is the fate of misplaced faith, which brings us to the U.S. bond market. The conventional way to measure general systemic risk in the U.S. bond market is known as the TED spread. It’s the market’s measure of how close we are to total financial meltdown — the much anticipated "Financial Reckoning Day"…

Technically speaking, the TED spread is the difference between interest rates on the 90-day U.S. Treasury and the 90-day Eurodollar deposit contract. Eurodollars are dollar-denominated deposits held by commercial banks outside the United States and in Europe. All things being equal, when they are packaged up and sold like U.S. bonds, the issuer must pay a slightly higher interest rate than on the 90-day T-bill.

The TED Spread: The Safe Haven of Last Resort

The issuer pays the higher interest rate because the U.S. government collects its revenues at the barrel of a gun, and commercial banks do not. This, presumably, makes the U.S. government a "safer" credit risk, e.g. less likely to default. And so the Feds don’t have to pay as high an interest rate to attract buyers.

The TED spread measures systemic risk. It’s premised on the belief that the U.S. bond market is the financial world’s safe haven of last resort. But what, to borrow a phrase from Michael Moore, if that’s a big fat lie?

A few weeks back, Addison Wiggin and I attended a luncheon in London offered by the folks at Arbor Research. Their lead research analyst, Jim Bianco, gave a riveting account of derivatives risks at Fannie Mae and Freddie Mac. After Jim’s speech, I asked him, over sandwiches, what I perceived to be a natural question. "What would happen if the credit quality of U.S. government debt were to be downgraded?" citing as possible causes the Treasury’s implied guarantee of Fannie and Freddie.

"It would never happen," Bianco replied, "That would mean the end of the modern financial system." Needless to say, Jim’s response got me thinking.

If the U.S. bond market isn’t as safe as you’ve been told, how would you know? How can you actually measure how close we are to the day of gloom and doom and $8,000 gold?

You’d begin to have an idea that the world was going to hell in a hand-basket if you could measure the spread between U.S. debt (which WE know to be risky) and debt that the market considers risky, namely baseline emerging market debt (BED).

The TED Spread: The BED Spread

A BED spread, you say? Ask… and you shall receive.

The BED spread (or BS as it’s been called by a few readers) is the proprietary indicator I developed to keep track of how close the U.S. government is to losing its reputation for creditworthiness.

To get it, I established a spread between emerging market debt and U.S. government debt. If I’m right about the U.S. bond market losing its gold-standard reputation, the spread should converge over time. U.S. government bond yields will rise as the dollar falls. And emerging market debt yields will fall, as it becomes comparatively less risky than dollar-denominated debt.

You COULD come up with an indicator by comparing the 10-year Treasury note with, say, an equivalent Argentine or Russian government note. But I prefer to take a broader measure of emerging market debt versus U.S. government debt. I picked two closed-end bond funds, GVT and EMD.

GVT is the Morgan Stanley Government Income Trust. One hundred percent of the fund’s assets are dollar denominated. When I first calculated the BED spread, about three weeks ago, GVT yielded 4.18%. That was higher than the yield on the 10-year note at the time (4.04%.) But GVT is an excellent proxy for the market’s general perception of the creditworthiness of the U.S. government because it’s a "basket" of government bonds. Here are its top five holdings and allocations:

1. U.S. Treasuries 30.28% 2. Short-term bonds 27.99% 3. Fannie Mae bonds 23.02% 4. Freddie Mac bonds 11.96% 5. Ginnie Mae bonds 6.75%

To represent the other side of the spread, emerging market debt, look at EMD, the Salomon Brothers Emerging Market bond index. Eighty-eight percent of the fund’s holdings are in sovereign (government) debt. While it’s not absolute, you’re basically comparing apples to apples… the bonds of emerging market governments versus Uncle Sam’s bonds. Here is how EMD’s top five holdings are allocated:

1. Brazil 23.57% 2. Mexico 20.87% 3. Russia 17.97% 4. Colombia 5.08% 5. Ecuador 5.05%

The TED Spread: The New BED Spread

When I first calculated the BED spread, EMD yielded 9.76%. So about three weeks ago, the BED spread was 5.58%. Based on the wide spread, the market did NOT perceive a great deal of risk in U.S. government debt. But that would soon change…

The second time I calculated the BED spread, the yield on EMD fell to 9.59%, while GVT’s yield was up to 4.22%. In bond speak, that means bond prices are up for EMD and down for DVT (yields and prices move in the opposite direction).

The new BED spread was 5.37%. Convergence approacheth. And it’s precisely what you’d expect, given the news in the bond market that week. Why?

First, Moody’s Investors Service upgraded the rating on Russia’s foreign-currency bonds by two levels. Russia’s Eurobonds were upgraded to Baa3 — the lowest investment grade level — from Ba2. Specifically, Russia’s 5% dollar bond due in 2030 gained 2.65 cents on the dollar in one day.

That particular bond is the most traded emerging market Eurobond. And it was bound to help EMD. While 17% of the fund’s total assets are in Russian debt, its single largest holding is $7.7 million worth of Russian government bonds — about 10% of its total portfolio.

The TED Spread: Other Emerging Market Bonds

Second, emerging market debt yields are converging with U.S. Treasury yields, because what’s good for Russia is turning out to be good for other emerging market bonds, including Brazil. Brazil’s 8% bond due in 2014, which is THE MOST widely traded emerging market bond, rose that week too, as yields fell. Brazilian bonds constitute 23.5% of EMD’s portfolio, and four of its 10 largest particular holdings.

On the other side of the spread — the U.S. government side — there was trouble in agency security land. Agency securities are otherwise known as the mortgage-backed bonds issued by Freddie Mac and Fannie Mae. And like a dream it can’t wake up from, the market is slowly recognizing how many bad credit risks Freddie and Fannie have taken… and how this directly implicates the creditworthiness of the U.S. government, whose implied guarantee of agency debt made it possible for Freddie and Fannie to get so overextended in the first place.

The problem reared its ugly head in Atlanta and Pittsburgh a week ago. Federal Home Loan Banks in both cities reported losses of $9 million and $7 million, respectively, for the third quarter. Both banks claimed the losses came from low mortgage rates "pinching off" interest income on their derivatives holdings.

Perverse, isn’t it? It’s those same low interest rates that have kept mortgage issuance and refinancing activity so high. Yet even what’s been historically good for the mortgage lenders is now turning out to be a problem.

Granted, $9 million and $7 million losses won’t break the bank. But the $200 million loss reported by the New York FHLB last month gets closer to breakage. THAT loss was chalked up to bad investments. And that brings us to the heart of the issue, with agency debt in particular and U.S. government debt in general.

Freddie and Fannie have been issuing mortgage-backed debt at a ferocious pace in the era of historically low mortgage rates. It’s dangerous risk-taking predicated on the ability of new homeowners to pay off mortgages AND the appetite of bond investors for mortgage backed securities. Yet that’s exactly the kind of investment that went bad in New York. And that’s the investment that will likely go bad all over the country.

The TED Spread: More and More Buyers

To keep expanding, the housing boom must attract more and more buyers. The voracious need for new buyers forces Freddie and Fannie to lend to riskier borrowers. To keep the boom going, the market extends more and more generous offers to less and less qualified buyers.

Eventually, Fannie and Freddie will be on the hook in two ways. They will have made loans to homeowners who can’t pay. And they will have packaged up those loans and sold them as bonds to bondholders who will, I’m guessing, demand payment.

Who will pay the bondholders when the homeowners default? The U.S. government? Santa Claus? The Daily Reckoning Paris office? You?

The U.S. government ALREADY has its hands full paying its own sovereign debt, not to mention Social Security, Medicare, and Medicaid. GVT, which has 30% of its holdings in Treasuries and 35% in agencies, is a great proxy for the credit problems of the U.S. government.

We saw it again this week, as the Treasury department reported a $374 billion deficit for the fiscal year ended in September. That number was better than the White House predicted back in July. But it’s not exactly good. And it wasn’t exactly good for the BED spread.

As of this writing, EMD yields 9.50% and GVT yields 4.24% for a spread of 5.26. That’s three weeks in a row of convergence… from 5.58 to 5.37 to 5.26.

The spread would be even larger if Treasuries still didn’t enjoy their reputation as safe havens. Yields on the 10-year note climbed as high as 4.46% before stocks retreated when the Conference Board reported that the leading economic indicators fell in September.

And who knows, after all? I could be completely wrong. Perhaps 10-year notes won’t rise much beyond 5%, if that. But I suspect otherwise. I suspect there is looming chaos in the bond market, spawned by Fannie, Freddie, and the simple belief that U.S. bonds will always be accepted as safe and dependable.

If you believe that, I’d like to introduce you to my big, fat friend in his bright red suit.

Warm regards,

Dan Denning,
for The Daily Reckoning

October 23, 2003

P.S. EMD and GVT are not perfectly representative of the yields on the underlying bonds in their respective portfolios. This is a function of how closed-end funds calculate yield. But in general, the BED spread gives you a pretty solid way to measure the big-picture perception of creditworthiness in the market.

And it’s also an excellent indicator for when to try and make money by "selling the dollar."

Dan Denning is the managing editor of Strategic Investment. He is currently researching the calamitous effects a correction of the U.S.’s "twin deficits" would have on the economy.

We don’t know any more than anyone else, but this rally looks as though it has finally exhausted itself, having retracted just a bit over half of its losses from 2000-20002.

The Dow fell 149 points yesterday. And this morning, the Tokyo market is down 554 points, for a 5% loss. It looks dangerous, dear reader; it looks dangerous. October is not over.

Despite all the blabber, stocks are still at near-record high prices… after the most stimulating gush of money and credit in history. But how many more tax cuts will there be? How much more will interest rates be cut? How much deeper into mortgage debt are householders willing to go?

Of course, everyone still expects the ‘recovery,’ now blossoming so sweetly in investors’ imaginations, to bear fruit. At least until after the elections next year, growing conditions should be good, they think; both the Fed and the Bush administration will pour on all the liquidity they can pump… and spread manure around everywhere. Who doubts that higher sales and earnings will soon bud out… leading to plump, juicy stock price gains?

And yet, what administration… what Fed chairman… ever wanted a slump? What kind of morons were running the Fed in the 1930s?

That was, of course, a long time ago, and much progress in central banking has been undoubtedly been made. But didn’t the Japanese try out all the miracle grow of modern macro-management? Didn’t they spread the manure so thickly that it began to stink? Didn’t they open all the spigots, valves, sluices and floodgates? Didn’t they drop interest rates to zero and hold them there for more than 5 years?

Sometimes, dear reader, things happen that you don’t want to happen… and that you do everything you can to avoid. When you eat too much, you gain weight — like it or not. When you spend too much, you grow poorer — whether you realize it or not. This is so obvious, we hate to bring it up. But who believes it? The lumpen — economists, investors, analysts, presidents — seem to think people can go deeper and deeper into debt, forever, and still get richer!

Ah, but it is a cold, cold world we’re livin’ in… as Percy Sledge put it. And, here in the Northern Hemisphere, it gets colder every day.

And what’s this? Looks like the pump done broke down… in a recent week in September, the money supply, M3, actually fell by $38 billion. Could be a fluke or something… or it could be the end of the world. We’ll have to wait to find out.

But what’s this? Bonds are rising. If there really were a recovery developing, bonds would be falling, foretelling higher interest rates and higher levels of inflation. Instead, bonds seem to be looking ahead to more of a Japan-style slump.

We don’t know what will happen, but we would be careful…

Over to Eric in New York…

———————-

Eric Fry with the news from Wall Street…

– All sunshine makes a desert, as the saying goes… but only farmers and new lovers seem to welcome the rain. Investors do not. Down here on Wall Street, all sunshine makes investors very rich… and very complacent. As long as the ascendant Nasdaq is casting a warm glow across investment portfolios from coast to coast, investors don’t give a thought to inclement weather.

– But yesterday, a sudden cloudburst of sell orders drowned the major equity averages in a deluge of losses. The Dow Jones Industrial Average found itself gasping for breath as it sank 149 points to 9,598, and the Nasdaq Composite dipped 2.2% to 1,898, its first close below 1,900 in two weeks.

– The dollar also struggled to stay afloat yesterday — slipping more than 1% against the euro to $1.181. The so-called resource currencies are faring particularly well against the foundering greenback. Yesterday, the Canadian dollar touched 76.7 U.S cents, a new 10-year high. The Australian dollar, trailing close behind its Canadian counterpart, reached U.S.$0.7044, its highest value versus the U.S. dollar in six years.

– It seems that the U.S. Treasury may have printed one dollar bill too many. Foreign central banks and foreign investors have more than enough dollars already, and seem to be running out of places to stash them. The darn things are everywhere. Your New York editor is doing his part to contain the proliferation of dollar bills. Whenever he sees a dollar bill lying on the ground, he stoops to pick it up… He hates litter.

– While the dollar and U.S. stocks were both sinking yesterday, the demand for financial lifejackets surged — 10-year Treasury bonds gained 22/32, dropping their yield to 4.26% from 4.35% at the previous close, and gold climbed $4.80 at $386.80 an ounce. Earlier in the session, the December gold contract touched an intraday high of $388 — its highest level since late September. Since Friday, the price of gold has jumped a dazzling $14.60 per ounce. Gold mining companies rejoiced in the yellow metal’s strength, as the Amex Gold Bugs Index added 1.4%.

– The most surprising aspect of yesterday’s stock market sell-off was that it hadn’t happened earlier. A "correction" was long overdue, based on the most recent sentiment readings. Folks had become so certain that each new day would bring another day of stock market gains, they rarely considered the alternative: a day (or two or three) of losses.

– The nation’s investors have rarely exhibited such universal exuberance. Let’s take a quick tour of the latest investors sentiment readings. The four most widely followed gauges of investor sentiment — Bullish Consensus, AAII, Investor’s Intelligence and Marketvane — all registered extremes of bullish sentiment as of Tuesday evening, immediately before yesterday’s trouncing. In fact, as professional sentiment-watcher Christopher Cadbury observes, all four of the gauges showed that greater than 57% of those surveyed are bullish.

– Never before have all four sentiment indicators produced bullish readings above 57% at the same time. The AAII survey, for example, which polls members of the American Association of Individual Investors, finds that 60.3% of its members are bullish, versus only 13.8% who are bearish. These sorts of extreme readings often presage the end of stock market rallies. At best, bullish sentiment does not reach an extreme when the buying is good.

– Cadbury also notes that all three of the CBOE’s options volatility indices have tumbled to multi-year lows, which indicates multi-year highs in investors’ complacency. The CBOE’s Market Volatility Indices — known by their various symbols VIX, VNX and VXO — are known as Wall Street’s "fear gauges" because they track the prices of various options. Simply stated, expensive options indicate high levels of fear, and inexpensive options indicate complacency.

– "A spike in the VIX often occurs near major market bottoms," Reuters explains. "As the market recovers and investor fear subsides, VIX levels tend to fall, suggesting an overly optimistic market susceptible to setbacks."

– As of Tuesday’s close, the VXO Index of S&P 100 at-the-money option prices had dropped to a 5-year low, the VIX index had slipped to a 7-year low and the VNX index, which tracks Nasdaq option pricing, had tumbled to an 8-year low. The fact that these indices have all dropped to multi-year lows says loud and clear that investor complacency has soared to a multi-year high. Complacency is in a bull market.

– Net-net, given the fact that stocks are not a bargain and the fact that the lumpeninvestoriat loves them anyway, the cautious investors may wish to remain cautious for a while longer. The cavalier investor will prefer to ignore all warning signs, on his way to amassing large paper profits and then losing them shortly thereafter.

———————-

Bill Bonner, back in Paris…

*** Amazon came out with an earnings announcement yesterday. If you ignore what CNN calls "all the bad stuff" the River of No Returns earned 11 cents per share last quarter. Investors were disappointed. The stock dropped 9%.

*** Oh, la la…the dollar got hit hard yesterday — down to nearly $1.18 per euro. The Australian dollar is at a 6-year high.

*** Arrgh! The price of gold shot up $4.80 to $386, well above our new $370 buying target. It keeps slipping away from us.

*** Of course, over the past year, you could have made a lot of money by not following our advice on companies such as Amazon.com. The stock rose 900% from its low of Jan. 2002. Instead, we have had you plodding along with gold — up only 25% or so.

Feeling lucky? Well, here’s our chance to get even with the tech buyers. Sell the techs, dear reader, sell the techs.

*** "Overseas jobs putting pressure on U.S. salaries," says a headline in the Atlanta Constitution-Journal. Well… what do you expect? In a globalized economy, there is bound to be competition on labor costs, as well as other prices. Are America’s high wages doomed? Well, maybe. The only way they could be preserved would be with massive capital investment and training, which would keep the output per hour so high that companies could afford to spend more for much more highly-skilled labor. This is how Switzerland, Germany, France and other European nations have managed to stay in business. But in America, there has been very little capital investment… less and less, in fact, as the economy has shifted towards consumption over the past 50 years. There is no way a consumer economy can keep wages high.

*** Speaking of hourly wage rates, we note that Americans already work far longer than others. High capital investments allow people to produce more per hour. In the absence of investments in new equipment and factories, Americans have been forced to work longer and harder — usually at service jobs — just to maintain standards of living. Research Addison did for our book Financial Reckoning Day shows average hours worked rose nearly 12% between 1973 and 2000. Real incomes barely rose at all. For men, they actually fell a little.

It is a cold, cold world we’re livin’ in, dear reader. A cold, cold world…

*** Speaking of the book, we note with a touch of irony, that the book is featured — right next to the bellicose Bill O’Reilly — on the Al Jezeerah website. We have no idea if they liked it… or even what they were saying about it… because the text is in Arabic. There doesn’t appear to be a way to order the book from the site, so for all we know they are pinpointing us as examples of imperialist tyrants… "the great Satan" personified… in any case,you can order the book here:

We’re told, too, that displays are now being set up in Borders and other bookstores around the country. Perhaps you can find a copy in your local bookstore. If you do, please be sure to let us know. You can be the DR’s eyes and ears on this project. Just send an e-mail to Addison here: addisonw@agora-eu.com with the details… location, etc.

*** And speaking of O’Reilly, we’re scheduled to speak in New Orleans at 10 AM on Saturday morning, November 1st. O’Reilly, the conference’s keynote, goes on at 11 AM. First, Arabic cyberspace… then New Orleans over Halloween… what’s next? Santa suits and a book signing in New York? Oh, la, la…