By Brian Kantor
We have suggested that the most important indicator of the state of global financial markets, of which SA is very much a part, is the direction of US long bond yields. Thursday and Friday last week provided a further demonstration of their importance for the markets and why they do what they do – and that is to respond the expected state of the US economy.
The better the economic news, the sooner the tapering of Fed injections of cash through additional purchases of US bonds and mortgage backed paper, currently running at USD85b per month, and so the higher the US long bond yields and yields everywhere else, including on SA government bonds.
The backdrop to these interest rate movements were reports on the US labour market. On Thursday afternoon (morning on the US East Coast, or 08h30), it was announced that initial claims for unemployment benefits had declined unexpectedly. This was good news about the US economy and so interest rates went up. On Friday at the same time the employment gains were announced: these were well below expectations – not good news at all.
The reactions in the markets are shown below. US Treasury bond yields went up on Thursday and down on Friday and the RSAs follow very closely (Figure 1). In Figure 2 it is shown how US Treasury bond yields go up and down in similar order and the rand/US dollar exchange rate follows in very close order as capital flows to and from emerging market bond markets responded to the higher then lower US Treasuries.
In Figure 3 we show the links between US bond yields and the S&P 500 Index. The good news that drove up interest rates was good news for the equity market on the Thursday. The initial reaction to the less good news on the Friday morning was to weaken the equity markets. But then through the Friday, the S&P 500 recovered its losses to end the day where it had started. This demonstrated a rather robust state of mind of equity investors. Perhaps the underlying fundamentals in the form of earnings reports and the outlook for them is proving supportive.
Of further interest, in Figure 4, is that the JSE followed the S&P 500 very closely throughout this period. We show this relationship through the index futures that offer more overlap than the spot indices.
QE: An exchange of bonds held by the public for cash issued by the Fed
QE easing may be regarded as an exchange of bonds for cash. The Fed holds more bonds and the banks hold more cash in the form of a Fed deposit. If the balance sheets of the US Fed and the Treasury were consolidated (as they should be since both are agencies of Uncle Sam) the consolidated US government balance sheet after QE is of the order of $2.4 trillion. It now shows lower liabilities to the public in the form of bonds that pay relatively high rates of interest, about 2.6% p.a for 10 year loans, and much larger liabilities in the form of bank deposits with the Fed (some $3.2 trillion) that pay much lower rates of interest, 0.25% p.a.
That these Fed deposits earn anything at all is something of an anomaly – something paid out of the goodness of the heart of Ben Bernanke to the shareholders of banks. It improves their income line and probably (controversially) makes the banks less reluctant to hold on to cash rather than lend it out.
But cash for bonds is likely to cause interest rates to fall and reversing the process – bonds exchanged for cash, as must eventually happen – should cause interest rates to rise. The market understands this very well. What it struggles with is the timing of this reversal, which will be dependent on the state of the US economy. And that is especially hard to predict.