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Market Update: Pax Vigilantes
November 16, 2009
Throughout history, hegemonic nations have presided over long periods of relative peace and stability around the world. The first 200 years of the Roman Empire brought about the Pax Romana; the British enjoyed a Pax Britannica after defeating France in the Battle of Waterloo; and Pax Americana describes the era of U.S. hegemony that began in the early 20th century and was cemented after World War II. Similarly, though markets continued to move quietly higher last week, investors were reminded that businesses and consumers very much remain under the dominion of a credit crunch.
The Federal Reserve's latest Senior Loan Officer Surveys revealed that U.S. commercial banks continue to tighten lending standards, albeit at a slowing pace. A net 17.0% of survey respondents said that they were tightening standards for consumer loans, while 14.0% reported tighter standards on commercial and industrial loans to large- and medium-sized businesses. The number tightening standards for small businesses was even higher, as corroborated by the NFIB survey of small business optimism for October, which revealed ongoing constraints on small business expansion due to lack of credit availability. But not only is it the supply of credit that continues to tighten, the demand for it has also been weak. A net 35.7% of the banks that were surveyed reported that demand for loans from large- and medium-sized firms fell, while 24.5% said the same about consumer loan demand, an even higher number than in the previous survey.
But while bank retrenchment has seemingly done little to quench risk appetites in the stock market, the real pax over which the credit crunch has presided has been the quiescence of government bonds. In the face of an economic recovery, ballooning issuance and a 15%-plus rally in global equities so far in the second half of this year, U.S. 10-year Treasury yields have actually fallen, while rates in Europe and the U.K. have also been subdued. In other words the so-called 'bond vigilantes', who many had thought would push yields higher as the economy began to recover, have thus far been missing in action.
At present, we see no obvious catalyst for a change in this relatively peaceful arrangement. Risk-averse banks may be curtailing loans to households and firms, but their purchases of government debt have exploded: outstanding commercial bank loans and leases have shrunk by 2.3% over the past three months, but over the same period bank Treasury purchases have jumped by over 5%; the combination of a potentially drawn out period of high unemployment, protracted recognition of losses on commercial real estate loans and regulatory uncertainty should see to it that bank credit extension to the private sector remains depressed for some time. Meanwhile a slow economic recovery, including restrained business capital spending, spells a long period of strong corporate free cash flow, contributing to the pool of global savings. Add to that the return of rising reserve balances in emerging Asia, much of which is being invested in U.S. government securities, and investors could be facing another bond 'conundrum' wherein yields fail to rise against all expectations.
That said, it may be worth acknowledging the risk scenario that could occur when conditions in the economy do improve, businesses do begin to speed up investment, the banking sector does begin to take on more risk and the government comes under increased competition for funds from the private sector. At that stage, rising bond yields could well pose a larger threat to the economic outlook. Even if the household savings rate continues to rise, the relatively small proportion of households assets for which Treasury securities account suggests that this source of funding will barely make a dent in the roughly $1.5 trillion deficit expected next year, or for that matter the roughly $800 billion budget shortfall expected on average over the next ten.
Perhaps in anticipation of this risk and given today's abnormally low real yields, the Treasury may be starting to lengthen the maturities of its bond issues from what are currently well below average levels; indeed just over half of last week's $81 billion auction was in 10-year and 30-year bonds. But while understandable from the government's point of view, this strategy may be risky as far as the economy is concerned. Even in the absence of a meaningful decline in bank buying, such an increase in supply may help push longer term private rates higher, especially given the approaching conclusion of the Fed's agency mortgage purchase program. Furthermore, China (the largest foreign holder of Treasury debt) has already begun to concentrate its buying at the shorter end of the yield curve, substituting some demand away from longer-dated bonds, and a continuation of this trend may add to the upward pressure on long rates.
Investors may ultimately find that they cannot have their cake and eat it too. While they may want to see further fiscal support, a more convincing economic recovery and a pick up in bank lending to the private sector, these developments may prove to be something of a Trojan horse as far as the bond market is concerned. The big risk in this scenario would be that the Pax Vigilantes, which has been an underpinning of stock market and economic recovery, is scuppered. Moderately higher long-term rates could be taken by investors as confirmation that the recovery is proceeding, but a sharp rise would cast doubt over its sustainability.
-- Stu Schweitzer & Ehiwario Efeyini, Global Markets Strategists
For professional investors only. This document is intended solely to report on various investment views held by J.P. Morgan Asset Management. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable but should not be assumed to be accurate or complete. These views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations.
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© 2009 JPMorgan Chase & Co.