Leverage Forces Selling of Fixed Income Securities – Mortgage REITS Flood Markets
We have recently argued that the big selling squall in bonds of all stripes in the face of declining inflation expectations was mainly an expression of a market structure problem: there is too much leverage in the market, and central bank policy is the culprit. By promising to leave interest rates at zero for as far as the eye can see and moreover continuing to buy massive amounts of bonds via 'QE' type operations, central banks have instilled a false sense of security among bond traders and investors, who have been tempted into leveraging their investments to the maximum extent possible in order to spruce up their meager yield income.
All it takes under such circumstances is for some trigger event to take place, be it Ben Bernanke's 'tapering' talk or the Bank of Japan's self-contradictory mad-cap 'reflation' policy, and all hell soon breaks loose. As we have pointed out, even those who thought they had made their portfolios bullet-proof and were prepared to deal with all eventualities, were surprised to learn that the one thing that actually happened was not on their menu.
Now we receive further confirmation that leveraged trades were indeed behind the rout:
“Annaly Capital Management Inc. (NLY)’s Wellington Denahan, head of the largest mortgage real-estate investment trust, told investors less than three months ago that reports REITs could threaten U.S. financial stability were as misleading as the media frenzy over shark attacks in 2001.
Since the May 2 comments, shares of the companies, which use borrowed money to make $400 billion in credit market bets, dropped about 19 percent through yesterday and the value of their assets has plunged after the Federal Reserve triggered a flight from bond funds by signaling plans to slow its debt-buying program.
REITs may have needed to sell about $30 billion of government-backed mortgage securities in just one week last month to maintain the amount of borrowing relative to their net worth, according to JPMorgan Chase & Co. Those types of sales deepened losses in the mortgage-bond market, which had the worst quarter since 1994, accelerated the exit from fixed-income funds and fueled a jump in home-loan rates to a two-year high.”
(emphasis added)
$30 billion of margin call related sales in one week just by REITs is a lot of wood. Regarding the above mentioned 'media frenzy', we see fairly little evidence for that – in fact, if anything, the potential danger of these leveraged bets is probably still widely underestimated. And it seems that the selling isn't really over quite yet:
The 10 year note yield has barely given back any of its recent gains. In fact, a new high for the move was reached last Friday – click to enlarge.
Credit Revulsion Could Spread
It is important to keep in mind that once such declines in a highly leveraged market begin, there is always a chance that they will spread over time to include all sorts of securities. The panic could spread to all sorts of debt paper (in fact, it has done that already) and eventually from there to equities as well. It is always possible that due to being severely oversold, all these markets will bounce sufficiently to repair stressed and overleveraged portfolios sufficiently for the party to resume.
Unfortunately, it is not very likely. It is more likely that those who failed to sell in the initial wave down will do so once a bounce gives them a chance to get out at slightly better prices – and the charts of EMB (an ETF that is a good proxy for emerging market bonds) and MUB (a municipal debt ETF) actually suggest that this is what is happening:
EMB – after an oversold bounce, the market has begun to look wobbly again – click to enlarge.
MUB's chart looks similar – click to enlarge.
We would guess that the situation will become clearer and potentially more volatile this fall. It is quite ironic that in spite of massive monetary pumping, weak global economic performance and declining inflation expectations, yields are doing the exact opposite of what one would normally expect. It seems to us that this is an indication of how dysfunctional and distorted markets have become in the wake of central bank interventions.
A Myth Destined to Crumble
Recently, Keynesian Joe Weisenthal of Business Insider posted a breathless apologia of Bernanke, demanding that his critics admit that he finally got something right and apologize to him (not mentioned is the fact that the same thing could have been said of Bernanke in 2006, and yet two years later it was crystal clear that he had been 180 degrees wrong about everything).
The instant gratification crowd apparently believes that the effects of interventions on such a grand scale can be discerned within a very short time, and that anything that is liable to happen later is akin to a case of inclement weather (a very popular phrase one gets to hear when these 'unexpected' events strike is 'no-one could have seen it coming').
However, it is already absolutely certain that the Bernanke echo bubble will end in massive upheaval that may well exceed the 2008 crash in intensity – only the timing is uncertain.
The great myth that is going to be destroyed at some point in coming years is that the central planners have 'things under control'. The recent sell-off in the debt markets is a first hint in that direction. Once the myth of the omnipotence of central banks is shoved rudely aside by reality, we will enter 'interesting times' as they say in China (incidentally, China appears very close to experiencing 'interesting times' itself). There is no way to avoid the collapse of a boom brought on by credit expansion – as Mises pointed out, the only question is whether it will happen sooner due to a voluntary abandonment of the credit expansion policy, or later, as a total catastrophe of the underlying currency system.
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