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Roaring Government Bond Market

Last week bond yields on 10 year treasuries fell to their lowest levels since March 2004. At 3.97% it was still well above the lows of 3.11% seen in June 2003. Long-term bonds (30 years) were even closer to their lows of 2003 at 4.26% versus 4.17%. But it wasn't just US government bonds that were falling to new yield lows, as other countries were experiencing a similar fall. Canadian 10 year bonds fell to 3.73% their lowest levels in more than 30 years. Long Canada's were in line with US Treasuries at around 4.22%.

Elsewhere Japanese bonds that were already at ridiculous low levels for several years fell further having one of their biggest falls in years. In Europe German 10 year bonds at 3.10% were at their lowest levels since the Bundesbank started tracking records in 1973. Not only that they were the lowest since the time of Bismarck in the 1880's. Short 2-year bonds at under 2% were actually lower than short interest rates offered by the European Central Bank. Indeed everywhere over the past several weeks bonds were falling in yield the fastest since the Asian flu, Russian default and collapse of Long Term Capital Management (LTCM) in 1998.

So what's going on? The Fed is raising rates yet long-term rates continue to fall. Normally short rates and long rates rise and fall in tandem even though there have been periods like the late 1970's and early 1980's when short rates rose faster than long rates creating a huge inverted yield curve. Yet here we have short rates rising even as long rates are falling continuing a narrowing of the yield curve.

The pat answers that we see regularly are that inflation is low so there is no need for long rates to rise; by raising short term rates it is setting the conditions to choke off inflation so long rates are falling in response; rising short rates are slowing the economy so long rates are falling in anticipation of a that slowing; huge inflows from foreign central banks purchasing US Treasuries are continuing to put downward pressure on rates; and, in a period of flat to down stock markets long bonds offer the best return even at 4%. As to a slowing of the economy there is some expectation that Central Banks may have to soon cut short-term interest rates. Swedish prime rates were recently slashed by 0.50% from 2% to 1.5%. There is speculation that others will soon follow especially in the moribund economies of the Euro zone.

But that is their problem they all seem too pat and as a result they may not be explaining other problems that are lurking behind the scenes. The problem may lurk in hedge funds. There are numerous reports beginning to circulate that hedge funds may be in trouble or more specifically hedge funds that are very active in the credit markets (junk bonds etc.). The recent downgrades of GM and Ford have widened credit spreads between weak credits (junk bonds etc.) and quality credits (the highest credit quality is of course US Treasuries). Financial regulators everywhere are stepping up their inspection and attempt to regulate the burgeoning hedge fund market. We are seeing this not only in the US but elsewhere as well including Hong Kong, Canada and Europe.

Over the past six years the number of global hedge funds is estimated to have grown by at least a third while the amount of funds under management has doubled. Hedge funds are huge traders and they are estimated to account for upwards to a third to half the volume of trading on the London and NYSE thereby providing huge liquidity to the markets. While the hedge fund industry is nowhere near to rivalling the mutual fund industry in sheer dollars under management, hedge funds are coming increasingly under scrutiny and in the news. And while hedge funds have traditionally been an investment of choice by the very rich and sophisticated investors the industry is increasingly taking funds from smaller and less sophisticated investors usually through the very mutual funds and pension funds where the small investor has his funds.

Witness the controversy surrounding Portus Investment Asset Management a large Canadian hedge fund that was ordered to discontinue operations by the Ontario Securities Commission. The US Securities and Exchange Commission (SEC) is concerned that they are unable to monitor and value hedge funds and that fraud and other misconduct could occur. Problems in hedge funds typically can only be discovered after the fact when considerable losses have occurred. We emphasize though that it depends upon the strategy being carried out by the hedge fund and it is not a blanket statement on all hedge funds. Many studies have shown that properly managed hedge funds can act as a hedge for a properly managed portfolio and therefore play an important role in investment management. Hedge funds are by their nature uncorrelated to other asset classes such as stocks and bonds.

Even the Bank for International Settlements (BIS) the central banks central bank is getting into the fray. In its annual report published on June 27, 2005 the BIS noted that two major risks. One was related to the huge and widening current account deficit in the United States that "could eventual lead to a disorderly decline of the dollar, associated turmoil in other financial markets, and even recession. Equally of concern, perhaps closer at hand, it could lead to a resurgence in protectionist pressure".

But besides the BIS's concern over the US Dollar they are also very concerned about the credit derivatives market. Credit derivatives have grown 6 fold to $4.5 trillion since 2001. The recent downgrades of GM and Ford did shake the credit derivatives market but according to the BIS the worst could be yet to come. The BIS is concerned about "how the CDS and CDO markets would handle a string of credit blow-ups or a sharp turn in the credit cycle".

Hedge funds or at least those that are involved heavily in the credit markets typically use huge leverage in order to obtain their high returns. And the use of leverage in the credit markets is not just the domain of the hedge funds industry as the major international banks often have groups on their credit and derivatives dealing desks that engage in similar strategies. Numerous hedge fund managers are former bankers who left the dealing desks of the institutional international banks to form their own funds and using credit supplied by the same banks and tapping into the same customer base of the international banks they have built their funds. As the number of hedge funds has grown concern is growing about the knowledge and quality of the hedge fund managers.

In 1998 the collapse of the hitherto little known hedge fund Long Term Capital Management (LTCM) almost brought the financial system. Such was the interconnection between the financial institutions that were funding LTCM. The hedge fund managers of LTCM were a former bond dealer from an international investment dealer and internationally known options specialists. There were also a number of hedge funds that wound up operations in the early part of the decade during the tech bubble collapse.

So could a huge hedge fund collapse or a series of hedge fund collapses bring down the financial system? In this interconnected world anything is clearly possible. The connection between hedge funds and a rallying bond market is possible sign of strain in the hedge fund markets. One strategy that highly leveraged hedge funds would run is credit spreads of buying high yield junk bonds and shorting US Treasuries. In a period of strain such as the downgrade of GM and Ford hedge fund manager in strategies such as this are forced to cover their positions as the spread trade goes against them. This would cause a rally in the high quality credit markets such as government bonds and credit spreads would widen.

As well while there may be problems in the hedge fund market Central Banks mitigate this risk through normal open market operations by the purchase of government securities from the banks thus providing the banking system with the needed liquidity to deal with possible credit problems elsewhere such as in the hedge fund industry.

The trouble is what if there was a systemic problem in the system that overwhelmed even the central bank's ability to provide liquidity to the banking system. Hedge funds may be allowed to go down but the same would not be said of the banking system. But at approximately $1 trillion globally the size of the hedge fund industry appears not to be at the size that could threaten the entire financial system. Unfortunately that is just assets under management and through the use of derivatives the actually size could be larger by 10 times or more. Certainly we see this with the banks themselves where derivatives are often 3 to 4 times or more the asset base. Despite the huge notional value of derivatives, as a credit risk they represent only a portion of the actual notional value.

The falling yields in government bonds accompanied as it is with a widening of credit spreads between the top credits and weaker credits bears watching carefully. The past few years has seen a huge drop in that spread so the current widening is a concern as it could be signalling more credit problems dead ahead. The last time that the spreads between short and long term rates was narrowing at the current pace was not only throughout the latter part of the 1990's but especially from 2000-2001. That period also saw a considerable widening of credit spreads that occurred during the collapse of the tech bubble. With the most recent breakdown it could be signalling that there are further credit problems ahead and this a potential real risk to global stock markets. A roaring government bond market is not necessarily all what it appears.


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