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Bonds May Be In For A Shock


To see thousands of traders at their most jittery, look no further than the $8 trillion bond market. They're all dreading the first Friday of May, when the government is set to issue its next jobs report.

Just look at what happened last time: On Apr. 2, an unexpectedly strong report of 308,000 new jobs set off the worst one-day rout in eight years for 10-year Treasury futures, which plummeted nearly 2% in price. The month before, an unexpectedly weak jobs report triggered a similarly violent reaction in the opposite direction.

While the two reports surprised economists, you would normally not expect payroll numbers to cause wild behavior at the world's biggest securities market. After all, the monthly jobs number is a lagging indicator of strength in the economy.

But today's bond market is anything but normal. It functions on a hair-trigger of speculation about just how soon the Federal Reserve will begin raising overnight interest rates. The market sold off sharply, too, the morning of Apr. 14, when the government announced a much bigger than expected 0.5% jump in consumer prices. Anxiety is so intense because the market is more leveraged and more hooked on cheap Fed financing than it has been in at least a decade. Traders fear the end of a profitable ploy known as the "carry trade," in which hedge funds, banks, and Wall Street dealers borrow money at dirt-cheap overnight rates and buy 5- and 10-year notes, which yield two to four times what they are paying for their borrowing.

Indeed, the market's bets are leveraged more than ever. Net borrowings by Treasury securities dealers, including big Wall Street banks, are up to nearly $800 billion, double the level of three years ago. Bond purchases by leveraged hedge funds and other financial institutions based in Caribbean tax havens have doubled, to $100 billion a year. And open interest in Treasury futures contracts, which are leveraged instruments, has also doubled, to 35% of the value of outstanding Treasuries.

The trouble is, the carry trade will turn sour as soon as it's clear that the Fed is about to start raising overnight rates, now at a 46-year low of 1%. Traders know that the time will come, but they're inevitably tempted to wait another day before closing their positions. Says James A. Bianco, president of bond-research firm Bianco Research LLC: "The minute they end the trade, they stop making money. That's what blinds everybody."

This leaves the Fed in a tricky position. It must find a way to engineer a gradual rise in interest rates throughout the bond market while avoiding the kind of violent selling that could roil trading firms, rattle bank lending, and paralyze borrowers, from corporations to home buyers. While the Fed's low interest rates worked well to stimulate the economy after the recession and the September 11 terrorist attacks, that cheap money threatens to become too much of a good thing. Before long, the Fed may need to begin raising interest rates to keep the lid on inflation as the economy gathers momentum.

In fact, bond investors have continued to suffer losses since the big jobs report. Yields on 10-year notes, which move inversely to their prices, climbed an additional 22 basis points, or one-hundredth of one percentage point, through Apr. 14, adding to the damage from the initial 26-basis-point leap. Some experts blame the continued selling on other signs of a strengthening economy, such as the strong retail sales report on Apr. 13. Others say the selling could originate with leveraged players who are trying to cut their losses after the Apr. 2 plunge. Either way, 30-year home-mortgage rates have risen to 5.8% from 5.3% in early March, according to the Mortgage Bankers Assn. Refinancing applications dropped 30% in the week ending Apr. 9, adding to worries that higher rates will crimp consumer spending.

NOT TAKING THE HINT

Fed Governors are well aware of the dangers of a chain reaction sparked by a rapid fall in bond prices. Some are trying to persuade traders to back off the carry trade. In an Apr. 1 speech at Widener University in Chester, Pa., Fed Governor Donald L. Kohn said: "Borrowing short and lending long is risky." He went on to warn that: "Investors are unlikely to be able to exit from these bets before the market starts to adjust." He likened the "probable" scene to a crowd trying to squeeze through a door at the same time.

Kohn may well be right. But he's fighting powerful forces of greed and complacency. Once in a carry trade, hedge funds, Wall Street dealers, and banks get paid to wait. They make money by keeping in place bets in which they borrow at overnight rates of around 1% and buy notes and bonds, such as the 10-year Treasury, which is now paying 4.3%. Like someone who says they'll eat better after the holidays, they're tempted to feed on the Fed's cheap money for another day. Until recently, playing chicken with the Fed has paid well. Wall Street banks and brokerages have benefited handsomely from the profits earned by bond traders.

Worse, the bond market is twice as leveraged as it was in '94, the last time the Fed had to unwind a low-rate policy amid a big carry trade, estimates Bianco. Then, investors were socked with the worst year of losses ever. Dramatic price moves in derivatives based on interest rates wiped out several hedge funds and forced Orange County, Calif., into bankruptcy.

Despite the damage in 1994, Fed officials still view that operation as a success. They doubled overnight rates, from 3% to 6%, in a year, preempting inflation and setting the stage for the late '90s boom. But officials want to avoid the pain this time around. In January, the minutes of their meetings show, Fed policymakers debated how to gently discourage bond traders and investors from expecting low rates to continue. They decided to rephrase a suggestion that they would keep rates low for a "considerable period" to say they could be "patient" instead. Traders initially flinched but then decided it was a distinction without a difference. They've maintained their leverage ever since, betting that the Fed will give them a clearer signal in time to unwind their positions.

Bond traders have shrugged off evidence of a strong economy. Yields on 10-year notes are still lower than they were last summer or even two years ago, even though the economy has been growing at 4% or better lately. Commodities prices -- which some analysts view as a weather vane of future inflation -- have climbed, and the stock market has rebounded. "The bond market is ignoring almost everything, but it is believing in the stability of short-term interest rates," says Robert P. Prince, co-chief investment officer at hedge fund Bridgewater Associates Inc. "This is a false sense of security."

Ideally, the market would handle the approach of higher short-term rates in an orderly fashion. The problem might resolve easily if the next few jobs reports were each to show about 175,000 new jobs -- just enough to ease pressure on the Fed to hold rates low. More traders might unwind their carry trades if the Fed did a better job of convincing them that higher rates could come any time. But, as markets often do, this one may rush from one extreme to the other. That could spread the jitters well beyond the bond pits. By David Henry in New York, with Rich Miller in Washington


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