Financial topics

[John]

*** LTRO leads to huge shock in Europe today

There's been an enormous drama in play in Europe today, and officials
are in a state of shock.

For months, pundits have been demanding that the ECB purchase toxic
bonds from Greece and Spain and Italy in order to bring down yields,
which are now unsustainably high. The ECB has been steadfastly
refusing to do so, because that would violate EU treaties and
regulations, and the Germans are opposed.

So the ECB did something different today -- a "Long Term Refinancing
Operation" or LTRO. The ECB offered unlimited amounts of euros in
3-year loans to banks at low interest rates. The analysts had
expected the banks to borrow only €250 billion or so.

So the first shock today was that 523 banks applied to borrow €489
billion, almost twice as much as expected. This announcement was
initially met with glee by investors, who assumed it meant that there
would be a lot of money floating around, and it would pour into the
stock market as usual, and stocks went up.

The ECB's intention with the LTRO program was to make lots of money
available to banks so that they would use that money to buy up toxic
bonds from Italy and Spain, and so that they would lend that money to
businesses, in order to promote growth. Thus, the LTRO is supposed to
be a form of quantitative easing.

However, that's not what happened today. The second shock was that
the banks used 61% of the 3-year €489 billion loans to pay off
previous 7-day, 3-month and 1-year loans from the ECB. Thus, the net
borrowing was much smaller, about €190 billion.

Furthermore, eurozone banks will have to come up with €750 billion
in 2012 to pay off other debts. So it's clear that the banks
are going to hoard this money to pay off their own debts,
rather than lending money to businesses or buying other people's
toxic bonds.

One UBS analyst said, "We still believe it is difficult to reconcile a
government desire for banks to continue buying debt with the need for
banks to reduce risk exposure associated with government debt." In
other words, if you want banks to survive, you'd better not expect
them to take on more toxic debt.

So this LTRO apparently will help banks get past the year-end
obligations and next year's debt payments, but will do absolutely
nothing for employment or productivity or economic growth in Europe.
It's just more money that will sit in the banks' mattresses, doing
nothing, not contributing to the economy and not contributing to
inflation.

John

[John]

Here's an additional angle to the above.

It seems that European banks HAVE been buying some toxic Spanish and
Italian bonds in the last few weeks, pushing yields down a little.

But once a bank has those toxic bonds in its portfolio, it's allowed
to use them as collateral to borrow money from the ECB. That's
apparently what's been happening.

So one possible unintended outcome of the LTRO is that it may
actually REDUCE bank purchases of toxic bonds, since banks don't need
to purchase them any more to get ECB cash.

John

[vincecate]

I would like to close by saying I do not think we are in a bond bubble. I want to say my evidence in part, is the fact that the 10 year yield on treasuries is running under inflation. But I really need to check my notes.

I think we are in a sovereign bond bubble. My evidence is that yields on treasuries are running under inflation. This is due to crazy high bond prices, driven up by Bernanke. As a rule bond interest rates should be higher than inflation rates so you get a positive real return on your money. This is like the rules for stocks and real estate. If you buy government debt and things hang together you are guaranteed to lose from inflation. A guaranteed loss is about as foolish an investment as there is. If they don't hang together (bond are bubble) then you lose big as the currency devalues and interest rates go up causing bond prices to crash.

[Trevor]

> A question: where do you find the information on bond yields that
> you post on this website?

The graphs that I post are from Bloomberg, with text added.

Here's a list of the URLs for the graphs I've used in the last few
months:

http://www.bloomberg.com/apps/quote?ticker=GBTPGR10:IND
http://www.bloomberg.com/apps/quote?ticker=GBGB10YR:IND
http://www.bloomberg.com/apps/quote?ticker=GBTPGR2:IND
http://www.bloomberg.com/apps/quote?ticker=GBTPGR2:IND
http://www.bloomberg.com/apps/quote?ticker=GDBR10:IND
http://www.bloomberg.com/apps/quote?ticker=GGGB10YR:IND
http://www.bloomberg.com/apps/quote?ticker=GGGB2YR:IND
http://www.bloomberg.com/apps/quote?ticker=GIGB10YR:IND
http://www.bloomberg.com/apps/quote?ticker=GSPT2YR:IND

You can get to one of these by googling something like the words
"Bloomberg Italian 10 year" (without the quotes)

John

Thanks for the information; may as well know what's going on while Europe burns.

[Higgenbotham]

I would like to close by saying I do not think we are in a bond bubble. I want to say my evidence in part, is the fact that the 10 year yield on treasuries is running under inflation. But I really need to check my notes.

I think we are in a sovereign bond bubble. My evidence is that yields on treasuries are running under inflation. This is due to crazy high bond prices, driven up by Bernanke.

Vince, if yields on treasuries are running under inflation, that fact by itself says to me that bonds are not in a bubble. The reason is that the low interest rate indicates demand for bonds is strong. If we add to that the other fact you stated or sometimes state as something like Bernanke is buying up 50% of the issuance each month, then it could be said that bonds are in a bubble. I'm not smart enough to know what the interest rates would be if the Fed weren't holding the extra bonds on their balance sheet. The Fed has done estimates and it seems like the influence they have attributed to QE is low, like 0.2%. It seems to me like it ought to be higher than that. Do you know more about that?

[vincecate]

Vince, if yields on treasuries are running under inflation, that fact by itself says to me that bonds are not in a bubble. The reason is that the low interest rate indicates demand for bonds is strong. If we add to that the other fact you stated or sometimes state as something like Bernanke is buying up 50% of the issuance each month, then it could be said that bonds are in a bubble. I'm not smart enough to know what the interest rates would be if the Fed weren't holding the extra bonds on their balance sheet. The Fed has done estimates and it seems like the influence they have attributed to QE is low, like 0.2%. It seems to me like it ought to be higher than that. Do you know more about that?

In a bubble the demand for something is so strong it drives the price up to levels that make it a bad investment. High demand is part of being a bubble, not evidence of no bubble. The bond prices have been driven up so high that the interest rates are crazy low. Inflation is 3.5% and 5 year bond interest is about 1%. This means a loss of 2.5% per year or about 12% on a 5 year bond. Crazy.

If you could magically stop the printing of money today then I think interest rates would jump to 4 or 5% over inflation or around 8%. As inflation went down the interest rates would go down from there to 4 or 5%. This 1% is very artificial. Someday we will all look back and it will be clear it was crazy.

I am 48 years old. Back around 1980 I took $6,000 saved up from my paper route and put it into a 3 year second deed of trust paying 20%. I am just sure you can not print money this fast and keep inflation down. They print/loan too much when interest rates are this far below inflation. Eventually interest rates will have to go up.

[Higgenbotham]

In a bubble the demand for something is so strong it drives the price up to levels that make it a bad investment. High demand is part of being a bubble, not evidence of no bubble.

Got it. Of course, you are right.

There's one thing I can think to add. Since the period of the bond is a long time, the investors may believe inflation rates will come down and that locking into a low interest rate now is still a good deal. I don't think that's the reason investors are buying US bonds now though. I think they are buying them in sort of a herd like fashion, thinking that they are safer and less bad than everything else.

In trying to think about why this wasn't obvious to me (that low rates on bonds indicates a bubble), most bubbles are based on greed and the idea that everyone is going to get rich, but the herding into bonds is based on fear. Nobody I've heard of is looking to get rich on higher bond prices.

[jdcpapa]

I would like to close by saying I do not think we are in a bond bubble. I want to say my evidence in part, is the fact that the 10 year yield on treasuries is running under inflation. But I really need to check my notes.

I think we are in a sovereign bond bubble. My evidence is that yields on treasuries are running under inflation. This is due to crazy high bond prices, driven up by Bernanke. As a rule bond interest rates should be higher than inflation rates so you get a positive real return on your money. This is like the rules for stocks and real estate. If you buy government debt and things hang together you are guaranteed to lose from inflation. A guaranteed loss is about as foolish an investment as there is. If they don't hang together (bond are bubble) then you lose big as the currency devalues and interest rates go up causing bond prices to crash.

Hey Vince,

I had trouble getting on the site last night for some reason. I have read your interaction with Higgy and believe there is more here than meets the eye. I believe these extraordinary times give cause to revist the traditional approach. I would like to establish a foundation that we can agree on and attempt to develop my position from there (right or wrong).

First, rather than refer to it as a sovereign bond bubble, I would rather address it as a sovereign debt bubble. The bond is the instrument that defines the terms and guarantee. However, it appears as a debt on the balance sheet. Further, the bond has a face value and a stated interest rate. Bond values and interest rates work inversely. When interest rates decline the value of existing issuances goes up. Likwise, when interest rates go up, the value of existng issuances go down. The 10 year treasury is defined as the "safe rate". In addition, the "safe rate" has always kept up to or exceeded inflation. The premium of the safe rate over inflation is growth.

Original issuances have a stated interest rate at or below 2% for the 10year and the 30 year is keeping up with inflation.


Thanks,

[John]

I had trouble getting on the site last night for some reason.

See the postings in the "Administrative Discussion" section.

John

[vincecate]

In a bubble the demand for something is so strong it drives the price up to levels that make it a bad investment. High demand is part of being a bubble, not evidence of no bubble.

Got it. Of course, you are right.

There's one thing I can think to add. Since the period of the bond is a long time, the investors may believe inflation rates will come down and that locking into a low interest rate now is still a good deal. I don't think that's the reason investors are buying US bonds now though. I think they are buying them in sort of a herd like fashion, thinking that they are safer and less bad than everything else.

In trying to think about why this wasn't obvious to me (that low rates on bonds indicates a bubble), most bubbles are based on greed and the idea that everyone is going to get rich, but the herding into bonds is based on fear. Nobody I've heard of is looking to get rich on higher bond prices.

People are moving in to short term bonds. I don't think they are trying to lock in these low rates. Typically people move into short term debt before they give up on the government completely and you get hyperinflation. It is like they think things will hold together for the next 3 months but they do not want to lock things up for 30 years. But as they all move into short term debt this alone also makes things more dangerous for the government. It makes it really easy for them to all get out soon. A company or government with long term debt is in a much safer position as the amount that it would have to refinance over the next year gets large when it is short term debt.

One funny thing about bonds is that people think about the interest rate. A low interest rate does not sound like a bubble.
But bond prices have to be high to get low interest rates.