Notes From Underground: What Were the Yield Curves Portending Late Last Week?

Before entering my thoughts on the significance of the year’s lowest close on the U.S. 2/10 curve, let me state that a Bloomberg news article by Alexandra Harris and TJ Marta is a must read in order to put perspective to the erratic nature of the markets recent moves. (It’s titled, “Traders Pull ‘Singed Fingertips’ From Markets As Risks Escalate.”) Every hedge fund of qualitative significance is struggling in an effort to make sense of all the potential “prairie fires” that exist around the world. Several months ago I blogged about the many risky bundles of dry tinder that could be ignited by a single spark. The Harris/Marta article provides an up-to-the-moment recap. (Full disclosure: Harris is one of my progeny, while Marta will have to blame others for his shortcomings.)

Last week saw some dramatic movement in the yield curves. Early in the week it appeared as if the long end of the curve was signalling that the FED was going to be on hold and the risk of any rate rise before year-end–the Art Cashin February prediction–was to be realized. But mid-week El-Erian and Bill Gross wrote pieces suggesting that a June hike was attaining a higher probability. The early steepening in the curves gave way as the shorter end of the curve saw yields rise while the 10- and 30-year bonds held. The Thursday “hawkishness,” as presented in speeches by George, Mester and Rosengren, saw the yield curves begin to flatten. Friday‘s strong retail sales data completed the sense of the FED having the data support to raise rates in June and the proof was in the way the BOND stayed well bid in the futures market while the shorter term yields struggled to find a bid until the SPOOS had a late selloff. The 2/10 yield curve closed at its lowest level of the year while the 5/30 curve put in a strong technical reversal week.

Now I am the first to argue that the ECB and BOJ‘s QE programs are causing great distortions in the global bond markets and therefore all technical moves are to be taken with great trepidation for any type of trend. There have been a plethora of articles detailing the ECB‘s impact on corporate bond markets as the beginning of ECB purchases of investment grade corporate bonds in June is creating a rush for multinational corporations to issue euro-denominated bonds. The ECB is pushing all interest rates to levels of zero-priced risks. A couple of weeks ago Unilever was able to sell four-year notes for EIGHT BASIS POINTS. In a weekend Financial Times article titled, “ECB Plan Fuels Round of Euro Issuance,” quotes Suki Mann of Credit Market Daily: “European markets are receptive to any deal right now because of the ECB.”

It is also noted that “around 22 percent of sales of euro debt have come from US-based companies in 2016 as they take advantage of the continent’s lower borrowing costs.” I bring this issue to the fore because it may be a reason for the flattening of the U.S. curve as issuers head to the EU where rates are extremely low and investors are starving for high quality bonds, especially as they have a guaranteed buyer unencumbered by price levels. The ECB has started become the reverse Statue of Liberty when it comes to bond buying. Give me your tired, poor bonds yearning to pay low rates. Regardless, it is important to be aware of the yield curves as a harbinger of problems for the economy.

The 2/10 closed at 95.7 basis points, but if it flattens to below 75 basis points the Fed will have a problem. The interesting thing on Friday is that the gold and silver were able to rally after early morning lows even as the curve flattened. Flattening curves are seldom positive for precious metals so if there is divergence it will be signaling further strength for the precious metals because of the age of central bank uncertainty. If you want proof for the effect of yield curves on GOLD research the Volcker period of 1979-82. Do I believe this time will be different? Yes, because the central banks have created so much distortion that the market views the FED, ECB and BOJ as lacking credibility.

If the U.S. curve flattens more this week we will get the needed test of theoretical propositions. But as you read the Harris/Marta Bloomberg piece, be well aware why I am stressing that everything is just a trade and nothing of a long-term duration as of yet.

***A developing problem for the ECB corporate bond purchases can be found in the giant French firms of EDF and Areva. EDF is the French utility provider, which is mostly owned by the French government. Areva is the manufacturer of nuclear reactors and a national champion for the spread of nuclear power around the globe. Both concerns need to issue large amounts of debt to shore up their balance sheets as both operate very capital-intensive businesses. But both firms financial situations are fragile as they carry heavy debt-loaded balance sheets. EDF is trying desperately to fund a major power plant project in the U.K., Hinkley Point, which caused several board members to challenge the viability of the firm if the project goes ahead. Areva is suffering from falling afoul of the French nuclear regulator after irregularities appeared in some Areva manufactured components which has resulted in the need for Areva to raise more capital to fix the problems.

The fact is that if the ECB were to openly purchase the corporate bonds of both companies the bank would be bailing out state-owned concerns and breaking the rules governing public support for industries. The ECB would own corporate debt of  troubled publicly owned companies. The Germans would ultimately supporting the French nuclear industry at the same time that German citizens have seen exorbitant increase in their electric bills as Chancellor Merkel has decided to mothball Germany’s nuclear power. When it comes to the EU nothing is straight forward. But is another argument why I would rather own German bunds then French oats. Take that Bill Gross.


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7 Responses to “Notes From Underground: What Were the Yield Curves Portending Late Last Week?”

  1. Chicken Says:

    Given we’re discussing fiat currencies, Non-performing ZERO-rate debt can be sidelined, no?

  2. Chicken Says:

    Say you were Company XYZ for instance, and could refinance your debt at near zero rate (paying infinitely more than government rate)…. as the cost of capital -> zero only principal is owed in a currency that’s unlikely to appreciate?

    But you’re paying infinitely more…..

    • yra Says:

      Chicken–but if the currency does appreciate then problems arise unless you either earn in that currency or have hedges on but if you use hedges the desirability could go away for the cost becomes too great to carry the trade.I know a real estate person who wanted to hedge out eighteen months of risk but by the time we ran the numbers it was better to take the exposure–so it all depends

      • Chicken Says:

        True, seems pretty common for the market to move in the opposite direction of the “news”.

  3. pittrader1988 Says:

    Japan just reported -1.7% GDP. QE working really well there.

    • Chicken Says:

      Full employment, I bet. Mrs. Watanabe-san has no idea of what’s next in the bag of failed-tricks.

  4. Tita Says:

    Yra, I am new to your blog and relatively new to trading. Thanks for sharing your in depth knowkedge of the global markets. I have been thirty for it. On your last post you recommended the article “Traders Pull ‘Singed Fingertips’ From Markets As Risks Escalate” by Alexandra Harris and TJ Marta. I didn’t find it. Can you provide a link to it or email me the actual article. Thanks!

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