Tuesday, December 2, 2008

Bond Price Rose After Settlement; USD Dropped – What are the Inspirations?

3-month T-bill price rose from 0.10% (“discount rate”) on Monday after the auction of 0.15% bulk to 0.04% on Friday after closing. 6-month T-bill price fluctuated from 0.39% closing last week to 0.54% after the sale of 0.55% bulk and then rose to 0.44%. 12-month T-bill price rose from 0.94% after the auction of newly issued 1.05% bulk to 0.81% on Friday after closing.

Longer term notes and bonds prices have similar fluctuation pattern: dropping after stock market advancement then rallying and rebounding back to a relatively high level.

Corporate bond yield has dropped by 12pts (for investment grade) and 140pts (for junk bond) to 7.98% and 22.00% respectively after the announcement of the bailout of Citibank and the grand scale stimuli plan by USA, UK, China, and other governments.

Despite the softening of government bond prices and the trace decrease of corporate bond yield, both governments bond prices and corporate bond yield remain high. Most of the economic data announced confirm the recession and project a dim future. Although stimuli plans by various governments help restore the market confidence and lure part of the cash reinvest on equity market, investors’ confidence is still weak, and their attitude is still risk-adverse. Hence, regardless the recent strong rebound on stock market, on average 15-20% from the lowest point in 14 days, money still seeks shelter and drives the bond price up amidst fluctuation.

The 3A banking and finance rates echo to the market worries on corporate survival: 6.34 and 7.11% respectively, comparing with 5.98% and 6.95% closing last week. Combining with the corporate bond yield rate, it shreds no light to the coming 3 months company performance.

Another factor that drags down the rising speed of bond price is the expected decrease of FED target rate and hence the over-supply of USD. USD rate against EURO and GBP have decreased from 1.24 and 1.43 to 1.27 and 1.55 respectively. Such decrease makes USD asset, including government bonds, unfavorable. It is temporary, though, for ECB and BOE will announce another wave of decrease of interest rate to cope with the existing shrinkage of credit. Yen, under the deleveraging, will surge due to unwind of carry trade. It will hammer the Japanese export stock accordingly.

The flooding of money may or may not cause another wave of asset appreciation. Two scenarios can be expected.

The first scenario sets on the competition of resources between government and corporate. So far the debt market has not changed its pessimistic view on corporate as shown on the high corporate loan rate and corporate bond yield rate. The enormous government stimuli plan, including direct bailout of troublesome corporate, guarantee on mortgages of home owners, and investment on infra-structural projects, will be done by the government directly to the market without intermediates. Although it avoids the problem of blockage of capital flow by banks for capital reserve, it weakens the multiplier effect since the value chain from the government directly to the corporate is short. Corporate receiving the fund will only save more retained earnings rather than reinvestment/expansion/distributing dividends so as to polish their balance sheets. Infra-structural projects usually result in redundancy and wastage of resources even though in the construction period the commodity price may rebound. None of the above can inflate the market with sustainable capital.

In addition, government needs to issue more higher-yield government bonds to raise funds from the market (without raising tax rate) for stimuli plan; thus, it competes for fund with and actually sucks the essential seed money from private sector. It is reflected on the lowering of government bond yield rate. With the expectation of the slow pace of equity market and company expansion as well as of the higher intervention from the government, market will invest and even speculate on government bonds. The auction price of the government bond will start initially lower to attract investors, and in spite of the lack of room of further decreasing interest rate, the lack of alternative risk justified instrument will drive investors to compete for government bonds and drive the price higher. As a result, the money supplied by the government will return to the government, with only a small part really stay in the market and roll. Corporate will follow the same route disregard of the higher cost of capital. Debt market will be the next appreciating market.

The other scenario will sets on the excessive supply of the money to the market and induce a hyper-inflation. This scenario will happen when government expands the state-owned sector over the private sector. Under the government direct management, political considerations will over-ride the economical and commercial ones. Labour will be over-paid and will under-perform. Organization size will inevitably grow, and efficiency of production will decrease. Stickiness of salary and government expenses through the purchases of unnecessary resources at over-stated price and the creation of redundant jobs may provide a temporary secure feeling to the public. They may spend more and induce a boost on internal consumption. Meanwhile, the corporate, under the government protection, will earn unexpected profits and be tempted to expand further. Bureaucrats will encourage these behaviors for their better evaluation of performance and corruption. These excessive demands will drive the equity market, commodity market and property market high and lower the attractiveness of bond market (and leave the government with even higher deficit). Yet, without substantial growth of GDP due to low efficiency, soon asset and consumer product prices will overshoot and result in hyper-inflation. Under such scenario, gold, and probably oil and agricultural product, price will shoot up high. Stock market will be highly volatile, and debt market will plummet.

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