Friday, 11 December 2009

Valuing bonds and dollar not easy anymore

Valuing bonds and dollar not easy anymore

9 Nov 2009, 0722 hrs IST, Bloomberg

"In price is knowledge," one editor used to scream at me. Whether or not you believed in efficient markets, you could be sure the price of a bond, a currency or a commodity was trying to tell you something about the outlook for growth, inflation or monetary policy; all you had to do was listen and translate. Not anymore. The ad-hoc combination of quantitative easing, government stimulus packages and zero-interest-rate policies has distorted markets beyond recognition.

In short, it is almost impossible to make a coherent argument for what a 10-year Treasury should yield, what a dollar or euro is worth, or whether to buy or sell copper or gold. Following are examples of markets driven mad by the recent enthusiasm for government intervention.

Unshackled from Bondage, Unhinged from Reality

The 10-year US government bond yields about 3.5 per cent, down from a five-year average of 4.14 per cent and its 20-year average of 5.57 per cent. Today's level, though, is about as reliable as the price of a collateralized-debt obligation in the depths of the credit crunch.

The combination of US authorities keeping the fixed- income market on life support by buying debt, plus commercial banks filling their balance-sheet holes with top-quality government securities, makes the Treasury yield an exercise in marking-to-myth.

$12.1 Trillion With bonds as your guide, you would never guess that the US Treasury plans to borrow a net $276 billion for the October-December period and a further $478 billion in the first quarter of next year, or that it expects to hit its $12.1 trillion debt ceiling some time next month.

If anyone is worried that the multi-trillion-dollar global Keynesian experiment we're in the middle of might backfire and ignite inflation, they haven't told the Treasury market. Maybe they have been whispering instead to the gold market. Gold has reached a record $1,095 per ounce this week after a 25 per cent gain so far this year. You know markets have gone mad when the 10-year Treasury couldn't care less that gold is at a record.

Credit Where It Isn't Due

Investors who own European corporate bonds have made more than 15 per cent this year on a total-return basis, according to figures compiled by Deutsche Bank AG. Subordinated debt sold by financial companies has delivered more than 26 per cent. In Europe's high-yield market, junk debt has returned a spectacular 67 per cent. You will struggle, though, to find anyone who trusts the rally. Too much money, with nothing better to buy, indiscriminately rushing back into the credit markets - that seems to be the culprit.

Never mind that the default rate among high-yield companies in Europe reached 9.3 per cent at the end of the third quarter, up from 6.4 per cent in the previous three months, according to Moody's Investors Service. The rating company is predicting speculative grade bond failures will peak at 10.9 per cent this quarter, before almost halving to 6 per cent a year from now. That seems way too optimistic, given the economic carnage wreaked by the credit crunch on corporate creditworthiness.

You know markets have gone mad when corporate bonds promise equity-style returns. It can mean only one thing: Investors should brace themselves for the equity-style risk of losing all of their money, not the security of regular interest payments.

Currency Carnage

The Japanese economy has been a basket case for years, with a second-quarter gross-domestic-product performance that was downgraded to an anemic 2.3 per cent pace from an initial 3.7 per cent estimate. The US economy, meantime, is lauded for its flexibility and endurance, as proven by its bounce out of recession to post 3.5 per cent growth in the third quarter. Nevertheless, the currencies of both countries currently seem yoked together in the hive-mind of the investment community. When risk aversion rises, the yen and the dollar climb, and we're told that investors are seeking the safety of havens. When risk appetite improves, the dollar and the yen both get trashed, unwanted and unloved. Moreover, the US currency is now talked about as a carry-trade favorite, something you borrow because it's cheap and easy, and you want to invest somewhere more lucrative.

You know markets have gone mad when the yen is perceived to be a refuge and the dollar is the catalyst of choice for re- inflating a global bubble.

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