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The case for a bond bubble

January 08, 2009 | The Globe and Mail

The concept of U.S. government bonds as a safe haven is taking a beating.

After investors abandoned just about any security that's not a U.S. Treasury, commentators are pointing out that the folks in Washington backing all this debt may not be the best credit risk around.

The idea that we are about to experience a bond bubble, along the same lines as the tech and the real estate booms, is getting widespread play. The Financial Times devoted several pages to the concept Wednesday, as did a fund headed by the former president of Bank of Montreal.

This debate is moving mainstream, with Merrill Lynch chef economist David Rosenberg writing in a report Wednesday: “We are certainly not bearish on Treasuries nor do we see them in some form of 'bubble' as so many now believe to be the case.”

What's the case for a bond bubble?

Well, first, consider the past: U.S. interest rates have fallen to historic lows, reflecting the ongoing economic crisis. Recall that when rates fall, bond prices rise, and vice-versa. As an asset class, U.S. Treasuries posted a fabulous 14 per cent return in 2008.

Now look ahead: U.S. government bond issuance is about to hit previously unimaginable levels, as incoming president Barack Obama finances several years of T-as-in-trillion dollar annual deficits. Foreign lenders, chiefly Chinese government agencies, have become America's biggest lenders.

The possibility that this all ends in tears was summed up Wednesday in a posting from a Toronto-based distressed debt fund called Recovery Partners, chaired by former BMO president and Canadian deputy finance minister Grant Reuber.

Recovery Partners CEO Alex Jurshevski, a credible Bankers Trust veteran, argued: “What the current configuration of U.S. interest rates and currency values essentially means is that we are in a bubble which has arisen in part because of policy actions taken to combat the deflating subprime bubble. It is an aftershock, not an equilibrium state of affairs.”

“We submit that this state of affairs is fundamentally unstable, unsustainable and financially very risky,” said Mr. Jurshevski. A serious bear on U.S. Treasuries, Mr. Jurshevski laid out the grim scenario for coming months and quarters. In his view:

- The U.S. will be unable to achieve issuance levels of its debt in sufficient quantities along the yield curve to keep its fixed/floating exposure ratios within acceptable bounds. Auctions will fail.

- Interest rates will rise considerably across the yield curve except where the Fed has most influence: one month and under.

- The U.S. dollar will sell off against the currencies of other countries whose financial policies are deemed to be more sensible or stable than those of the U.S.; and, importantly, it will also depreciate in commodity terms.

- The U.S. may decide to print money to buy its way out of the situation.

- In the extreme, the U.S. may have to fund itself in currencies other than the U.S. dollar because foreign investors go on strike until it cleans up its problems.

By Andrew Willis

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