| |
| Over the last 60 days or so, the bond markets in the US have experienced a bust of epic proportions, with yields on the benchmark 10-year bond backing up by approximately 150 basis points(1.5 per cent) from 3.1 per cent to 4.6 per cent currently. |
| |
| A rout of this magnitude(50 per cent) in such a short period is unprecedented. As for the reasons for this bust, there are basically two. |
| |
| Firstly market participants were convinced that the Fed would have to eventually resort to unconventional monetary policy measures to stave off the threat of deflation. |
| |
| These measures were widely perceived to involve Fed purchase of long dated securities to keep yields low. In their last meeting, the Fed and Greenspan made it clear that they were prepared, if required to lower the Fed funds rate to zero from 1 per cent currently and the likelihood of having to resort to unconventional monetary measures was more remote than popularly perceived. |
| |
| To the extent bond yields were artificially depressed because of these expectations of unconventional monetary measures, this has now got corrected. |
| |
| The growing belief that the US is on the verge of a self-sustaining economic recovery, with GDP growth expected to exceed 4 per cent in the second half of 2003 has only added to the pressure on yields. More and more economic data supports the contention that the economy has begun to accelerate. The second reason for the sharp surge in yields is due to technicalities dealing with the hedging of mortgage portfolios. As yields rose, the risk of mortgages being prepaid reduced and thus extended the duration of these assets, changing the dynamics of hedging and demand for long dated assets. |
| |
| The scramble by various institutions to hedge out these risks has only exacerbated the fundamental selling pressure on long dated securities. |
| |
| Whatever be the causes, the fact remains that yields have increased sharply and this will have consequences. Two obvious and important areas where the rise in yields will have an impact are in equity market valuations and the outlook for consumer spending. |
| |
| As for equity market valuations, most people including myself do not expect this rise in yields to sabotage the market, unless yields(10-year bond) significantly exceed 5 per cent. |
| |
| At that level, the multiple compression effect of higher interest rates will overpower any perceived improvement in corporate earning prospects. |
| |
| Most interest rate based models showed the market to be at least two standard deviations cheap when yields were near 3 per cent, and now show the markets to be near fair value. |
| |
| This swing in perceived value is not that important, as most users of these models anyway tended to ignore the cheap equity market signal for precisely the reason of an artificially low interest rate being used to determine relative attractiveness of bonds versus equity. |
| |
| Many people felt this was more a reflection of how expensive bonds had become and not how cheap stocks were. Now that interest rates have normalised, unless they keep rising and drive equities into expensive territory, the current rise in yields should not hamper equities. |
| |
| The other issue is that to an extent the steepening of the yield curve and rise in yields also reflects an improvement in economic and corporate earnings growth prospects. |
| |
| Given the collapse of earnings over the last three years, any signs of improvement on this score is a big positive for the market. Markets till recently had continued declining for three years despite falling yields due to the collapse of earnings. |
| |
| If investors are able to gain more confidence on the outlook for corporate earnings, this would more than compensate for the current rise in yields. |
| |
| The second more contentious issue is the impact of the backup in yields on the economy in general and consumer spending in particular. A first order impact of rising yields on the economy will be in the home-building area. |
| |
| This is the most interest sensitive sector of the economy and most models predict a decline of about $ 20 billion in new residential construction and a reduction of 0.2 per cent in real GDP growth in 2004(GS estimates)due to the change in yields. |
| |
| The more interesting debate is the impact on consumer spending. It is widely understood that the surge in mortgage refinancing over the past three years, by both reducing monthly payments as well as enabling cashouts has provided a strong fillip to consumption in the US. |
| |
| However with the recent back up in yields, the effective interest rate offered on new mortgages is now almost equal to the average effective rate paid by home owners on their current mortgages, thus providing little incentive to refinance. |
| |
| Not surprisingly, mortgage refinancing applications have dropped by 60 per cent in the past two months. |
| |
In terms of trying to quantify this impact, Goldman Sachs has come up with a good metric they call mortgage equity withdrawal(MEW), which breaks up the cash flow into three components (a) Cash-out refinancing(when home owners take out a new bigger mortgage to repay the existing and pocket the difference (b) Home equity loans(similar to a second mortgage) (c) Turnover
|
