Treasury bears, don’t growl too early

The article was firstly published on March 22, 2012 on China Daily.

In the past two weeks, the US Treasury market has experienced one of the most serious selloffs in the last 12 months. As investors dump their Treasury bonds, the Treasury yields, which go inversely with prices, have soared substantially with the 10-year benchmark yield rising more than 30 basis points from slightly above 2 percent to nearly 2.4 percent in less than 10 days. The selloff started after the Federal Reserve released its statement last Tuesday as Fed Chairman Ben Bernanke refused to give any hints on the possibility of further bond buying. The expected decrease in demands for Treasuries from the Federal Reserve has weighed on the Treasury prices and been widely taken as a sell signal by the Treasury market.

There is a mainstream thought in the market following this broad-based sharp rise in Treasury yields, which suggests the decade-long bull run in Treasury market has come to an end and trillions worth of money outflow from the Treasury market will soon trigger another rally in equity. However, neither these views convince me.

I would argue that the downward pressure on Treasury yields is rather long term and structural. Like many US economic watchers pointed out, the labour force participation rate (the ratio between labour force and population) in the US has been dropping from its peak in April 2000 at 67.3 percent to the latest reading at 63.9 percent in February 2012. The continuously dropping participation rate suggests not only the fact that a lot of American workers lost their jobs in the past decade but also a phenomenon whereby millions of baby boomers started to retire.

For an economy with aging population and decreasing productivity, the benchmark interest rates, like Treasury yields in the US, staying ultra-low is nothing new in modern economic history. In fact, if Japan is any guide for the US, the Treasury yields at today’s levels are never too low to sustain. The 10-year yields on Japanese government bonds had firstly dipped below 2 percent in August 1997 and almost stayed below this important threshold since then in the past 15 years. Until recently, the Japanese 10-year yield is still lingering around 1 percent.

In addition, it is also not favorable to the US government if Treasury yields, which are laterally their borrowing costs, are really going up in the coming years. Since the crisis in 2008 hit the US financial sector badly, the US government pumped trillions of dollars into the system and most of this money was financed through issuance of short to medium-term Treasuries.

As time goes by, most of this debt will turn mature in the coming three years, implying that the US government will need to re-finance the debt in the spot market at prevailing interest rates. According to Reuters’ data, 48 percent of the total outstanding government-related debt will become due by the end of 2014. A rising interest rate would basically mean a higher re-financing cost and worsening indebtedness for the US government. We have every reason to believe from an economic and political point of view that interest rates in the US would remain low in the coming three years.

Although I do expect to see Treasury yields to further normalize after a panic 2011 on the back of European debt crisis and rise to more reasonable levels (i.e. 2.5 percent-3 percent for 10-year Treasuries), the recent selloff is hardly taken as a long-term turning point in the Treasury market, needless to say as a signal for another equity rally ahead. My advice to those Treasury bears would be: don’t growl too early.

How far can the equity market catch-up play go?

The article was firstly published on March 7, 2012 on China Daily. 

At the end of 2011, expert opinion on equity markets prospects was so one-sided and bearish with the fear of a disorderly default in Greece, European banks’ insolvency problem and the possible collapse of the Euro system amid the refinancing peak in March and April of 2012. Despite all this one-sided bearishness, the Hang Seng Index, like most of its peers globally, finished the first month of 2012 with more than 10 percent gains and kept up the momentum in February.

The reason we saw the best start to the year since 1991 for Hang Seng Index is that the bearish consensus back then had largely overstated the equity market risks. One way to measure the perceived risk level is to look at the risk premium that equity investors require to gain in excess of US Treasuries. If the risk premium (the spreads between Hang Seng Index’s earnings yield and 10-year Treasury yield) widens, it indicates equity investors demand a higher safety margin to hold equities instead of the risk-free US Treasuries. For the last quarter in 2011, the risk premium mostly remained at an elevated level at above 8 percent, indicating equity investors were very pessimistic. With the one-sided pessimism in the market that already priced in a lot of bad news, the lack of fresh bad news together with various central banks easing policies around the world has buoyed the market by a meaningful margin in a short period of time.

I didn’t anticipate the extent of the current rally in risk assets, but it was well expected that the one-sided bearishness in the equity market could not sustain as other risk proxies, like the volatility index, indicated that the market’s risk level was actually going down instead of up back in December 2011. The volatility index (VIX for S&P 500, VHSI for Hang Seng Index, etc) that measures the implied volatility in the option market of respective equity index is often called “fear gauge” with its sensitivity and inverse correlation with the equity market. Since implied volatility is an important variable in option pricing, the volatility index would normally see a spike amid panic market when investors are rushing to buy protection and bid up the price of put options.

For the first 11 months in 2011, the implied volatility (VHSI) has been closely tracking the Hang Seng Index’s risk premium as both of them are regarded as good proxies for indicating the perceived risk level in the market. However, these two lines decoupled since December, especially after the announcement of the first long-term refinancing operations (LTRO), a funding facility by European Central Bank that lent out nearly 500 billion euro to European banks. The decoupling of the two lines basically reflected the option market was pricing in a lower market risk ahead but the equity market was still reluctant to accept the fact that there was any market improvement.

After two strong months for equities, it is obvious that the option market got the better of the equity market when it hinted a rally back in December with the drop in implied volatility. Indeed, the way we see the recent rally in the past two months is that equities have been playing catch-up and pricing in the improved market sentiment after around a month of delay compared to the option market.

As we reach the end of this quarter, the question for both institutional and individual investors is that how far this catch-up play in equity market can possibly go. With the second LTRO that lent out another 529.5 billion euro, it is hard to imagine what sort of good news to expect moving forward.

In addition, the volatility Index (the VIX Index) demonstrates a strong mean-reverting pattern, which seems set for a rebound as it approaches low end of the range. If history repeats itself with the volatility index leading the equity market, a widening equity risk premium and therefore a weak equity market are expected in the coming months.

Although it is unwise to bet against an up market as it can always stay irrational longer than anyone can stay solvent, adding more risk positions to the portfolio at this point in time seems equally reckless.