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May 13, 2005
Last week's rise in rates has reversed, and then some. The 10-year T-note has been sub-4.15% today, flirting with a break below 4.00%, and 30-year fixed-rate mortgages can be found as low as 5.625% without fees.
Nobody with good sense knows for sure why long-term rates have broken down (of course, that "good sense" qualifier dismisses a majority of those trading bonds).
For sure, long-term rates have decoupled from economic fundamentals. Rates have been falling for six weeks on the theory that the economy is slowing down, but the newest data says no, not hardly. April retail sales doubled the forecast, and 1st quarter GDP growth will soon be revised from 3.1% and shaky to close to 4%.
In another decoupling, bonds used to improve when oil prices rose, on the theory that high prices would slow the economy, or resulting inflation would force the Fed to slow it down. Oil is down to $48/bbl today, and accumulating inventory and reduced consumption in the US and China portend a further price decline.
The consensus Fed forecast is still the same: another .25% on June 30 and August 9, and a stop at 3.50%. Doesn't make good sense to me: the long-rate rally is adding stimulus that the Fed is trying to remove. Why would the Fed stop short?
If bonds are not rallying on the economy, oil, or the Fed, then on what?
It seems that the kids have been playing with the chemistry set again. Prudent adults are evacuating the neighborhood, seeking safety by buying long Treasurys.
Wall Street heavily rewards new ideas, but the new-idea laboratory is prone to three recurrent failures: first, whatever accident blew the eyebrows off the guy with the last can't-miss concept can't possibly happen again. Second, any new idea that makes money will make a lot more if you borrow a zillion bucks in order to make a bigger bet. Third, belief that when you need to sell, nobody else will need to.
Beginning roughly in 1983 with the invention of modern mortgage hedging, the biggest, richest, most accident-prone lab on the Street has been the "derivative" market. A derivative security is a synthetic construct (some would say imaginary), a golem made of pieces and aspects of actual securities like stocks and bonds. The names -- collateralized mortgage obligation (CMO), swap, swaption, embedded option -- indicate their hybrid nature. The total outstanding today: $220 trillion.
These synthetics are used to protect against market swings (true hedging, as opposed to misnamed "hedge fund" delinquents), and to magnify gain from any unusual deviation from normal market-to-market variation in price. All use historical market modeling to infer future market movement. The models can produce fine returns, especially if leveraged to the eyeballs, until a market behaves in an "impossible" way. Then the models produce fantastic losses -- and sometimes black-hole risk to the financial system (LTCM in '98 was the closest call so far).
In the last five years, the risky end of the Street has been making good money by selling insurance against credit default. Buy a GM bond and credit insurance, and you're protected if GM tanks. Recently, kids have been fooling with "synthetic collateralized debt obligations" (CDOs are not to be confused with CDs), taking in credit-insurance premiums but making "risk-free" offsetting trades. See, that way, if the model holds, you keep the whole premium and the trades pay the claims.
The GM CDO model went ka-BOOM last week when GM bonds went down in value, but GM stock went up. Couldn't possibly happen, but did. In the week since, other variants of the CDO game look vulnerable if shaken or dropped.
Money goes to Treasurys for safety, but also in hopes of a profit from a really big bang. If you're looking for a better deal on a mortgage next week, you're in there with the best of the bond-market ghouls, hoping the CDO business goes up like Robin Williams' Flubber basement.
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