Forget Europe And China, All Eyes Are Turning To Crumbling Treasuries

Business Insider: "

Every day it seems the US markets get knocked around due to some events happening overseas.

China and Europe have been trading places as the tail wagging our dog, though last week was mercifully light on China news due to the New Year.

And seeing as they've just finished a round of delivering fresh economic news and a rate hike, we might expect things to be somewhat quiet out of Beijing in the near-term. The situation in Europe remains anyone's guess.

So now the focus turns back to America, and our own unique set of issues.

Two big themes both relating to interest rates will dominate the discussion. First there's Bernanke's fiddling with the uber-short end of the curve (so short, even, it doesn't actually show up). And then there's the fresh focus on long-term yields.

That's where the battle is going to take place.

Treasury bears have been out in force for awhile, but they smell blood right now, in part helped by some recent very-weak bond auctions.

Here's a quick recap of some posts on the subject:

• The one chart that screams higher interest rates
• If you thought the yield curve was steep now, you haven't seen anything yet
• The much-anticipated Treasury selloff is no long a matter of 'if'
• CHART: Wall Street's gravy train is about to smash into a brick wall

So there you go. The below chart from Waverly Advisors, which we've run before, is a nice quick way of visualizing the changing curve year over year.

Goodbye to the risk-free rate

FT Alphaville:

Morgan Stanley’s European Strategy team, headed by Graham Secker, put out an interesting note on the rising cost of capital on Monday.

And it’s not a cheery read if you happen to be a sovereign issuer, given the shift of private-sector debt into the public sector.

According to the MOST analysts, the most important macro theme for the next few years will likely be the ease (or difficulty) at which sovereigns pay down the deficits they’ve incurred during the course of the financial crisis.

Greece, unfortunately in that case, may only be a taster of what’s to come. As the analysts note:

Greece may well prove to be a taste of things to come, in our view. However, the speed and extent of any contagion are hard to predict . We think that the 50-year+ low in government bond yields (real and nominal) seen in this cycle will not been seen again for many years to come. In effect, the size of the public debt burden means that the ‘risk-free rate’ has become more risky.

And here’s a rather enlightening chart produced by the bank to illustrate which countries are likely to come under more pressure than others in this regard:

Collectively in Europe, Morgan Stanley notes EU banks have something in the region of $1,000bn in debt to rollover in the next two years. Due to the contagion factor from Greece, this will have to take place at a much higher cost of capital.

In the irony of the day, however, the analysts forecast it will be the banks that have substantial scope to buy much of that government paper.

Not that they won’t be inclined to charge for it (emphasis FT Alphaville’s):

Many investors look to the banks as a natural source of demand for sovereign debt going forward, but we think this is likely to come at a cost in terms of less credit availability in the wider economy and lower ROEs for the banks themselves.

A fact that Morgan Stanley’s analysts say — irrespective of where rates go — will lead to a higher cost of capital for all.

To recap: That would be banks over-charging sovereigns for the debt they incurred by rescuing the banks.

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Ambrose Evans-Pritchard in Telegraph has some more informations form this report:


European banks face showdown over €1 trillion of debt

The bank has advised clients to prepare for chillier times as monetary tightening begins in the US and China, causing major spill-over effects in Europe.

Roughly €560bn of EU bank debt matures in 2010 and €540bn in 2011. The banks will have to roll over loans at a time when unprecedented bond issuance by governments worldwide risks saturating the debt markets. European states alone must raise €1.6 trillion this year.

"The scale of such issuance could raise a significant 'crowding out' issue, whereby government bonds suck up the vast majority of capital," said Graham Secker, Morgan Stanley's equity strategist. "The debt burden that prompted the financial crisis has not fallen; rather, we are witnessing a dramatic transfer of private-sector debt on to the public sector. The most important macro-theme for the next few years will be how easily countries can service and pay down these deficits. Greece may well prove to be a taste of things to come."

Lenders will have to cope with a blizzard of problems as new Basel rules on bank capital ratios force some to retrench. State guarantees are coming to an end, which entails a jump of 40 basis points in average interest costs. They must wean themselves off short-term funding as emergency windows close, switching to longer maturities at higher cost.

Worries about Europe's second-tier banks help explain why Berlin is warming to plans for a €25bn rescue for Greece. Germany's regulator BaFin has warned that €522bn of German bank exposure to state bonds in Portugal, Italy, Ireland, Greece and Spain may pose a systemic risk if contagion causes "collective difficulties of the PIIGS states".

A BaFin note obtained by Der Spiegel said Greece could be the trigger for a "downward spiral in these countries, as in the case of Argentina", leading to "violent market disruptions".

Citigroup said Europe's 24 largest banks must raise €720bn over the next three years, in a world where investors want a higher return for risk. "This could eventually drive up funding costs meaningfully," it said.

It said a mix of higher credit spreads, rising rates, and Basel III rules could "eat up" 10pc of bank earnings. While most lenders can cope, it will dampen economic recovery.

Morgan Stanley said the benchmark cost of capital – known as the 'risk-free rate' – is rising because governments themselves are becoming a riskier bet, with ripple effects through the entire economic system.

Investors should be cautious about corporate bonds, sectors such as transport, media and telecoms with high net debt to equity ratios and certain countries. The net debt to equity of the corporate sector is 189pc in Portugal, 141pc in Spain, 85pc in Italy, and 82pc in Greece, compared to 46pc for Germany, 39pc for Britain and 26pc for Sweden.

Morgan Stanley expects equities to prosper, but not until the current "growth scare" is digested by the markets. ¾"The current correction phase in equities is not over: there may be rallies but we recommend selling into strength."

The World's Biggest Debtor Nations

From CNBC... HT CrossingWallStreet.com
20. United States
External debt (as % of GDP): 95.9%
19. Australia
External debt (as % of GDP): 108.8%
18. Hungary
External debt (as % of GDP): 124.2%
17. Italy
External debt (as % of GDP): 154.6%
16. Greece
External debt (as % of GDP): 175.3%
15. Spain
External debt (as % of GDP): 184.7%
14. Germany
External debt (as % of GDP): 189.4%
13. Finland
External debt (as % of GDP): 205.7%
12. Norway
External debt (as % of GDP): 208.9%
11. Hong Kong
External debt (as % of GDP): 218.8%
10. Portugal
External debt (as % of GDP): 231.5%
9. France
External debt (as % of GDP): 247.2%
8. Austria
External debt (as % of GDP): 268.9%
7. Sweden
External debt (as % of GDP): 275%
6. Denmark
External debt (as % of GDP): 315.2%
5. Belgium
External debt (as % of GDP): 345.6%
4. Switzerland
External debt (as % of GDP): 390%
3. Netherlands
External debt (as % of GDP): 395.6%
2. United Kingdom
External debt (as % of GDP): 427.6%
1. Ireland

External debt (as % of GDP): 1,352%