can someone explain this sentence “Traders drove a surge in interest rates because they feared inflation and a mounting federal budget deficit.” ------------------------------------------------------- http://www.nytimes.com/2008/08/13/business/worldbusiness/13credit.html?em=&pagewanted=print A year after financial tremors first shook Wall Street, a crucial artery of modern money management remains broken. And until that conduit is fixed or replaced, analysts say borrowers will see interest rates continue to rise even as availability worsens for home mortgages, student loans, auto loans and commercial mortgages. The conduit, the market for securitization, through which mortgages and other debts are packaged and sold as securities, has become sclerotic and almost totally dependent on government support. The problems, intensified by bond investors who have grown leery of these instruments, have been a drag on the economy and have persisted despite the exercise of extraordinary regulatory powers by policy makers. “The mortgage finance system in the United States has been badly damaged,” said Anthony Lembke, co-head of investments at MKP Capital Management, a hedge fund firm that is a big investor in mortgages. “There is definitely some reinvention that will need to occur, and that will include some explicit involvement by the government.” Bond investors first stopped buying private home mortgage deals, then shunned commercial mortgages. Now, they are becoming wary of credit card debts and auto loans. In the first half, private securitizations reached just $131 billion, down sharply from $1 trillion in the same period last year, according to data compiled by Thomson Reuters. Some analysts say investors are acting like the “bond vigilantes” of the 1980s and early 1990s. Those traders drove a surge in interest rates because they feared inflation and a mounting federal budget deficit. “The bond vigilantes took law and order in their own hands and pushed yields up, which would slow down the economy and bring down inflation,” said Edward E. Yardeni, an investment strategist who is credited with coining the term. “This time the bond credit vigilantes are refusing to go into the saloon and start drinking what Wall Street’s financial engineers are mixing.” For their part, bond traders say that the weakening economy is making it harder for them to invest with confidence because even areas like auto loans, credit cards and commercial mortgages that once seemed secure now look vulnerable. They are also worried that demand for the securities they trade in will be weaker in the future as banks, brokerage firms and other investors are forced to sell. Their reluctance to invest implies that credit, whether for businesses that want to expand or people who want to buy homes, will remain tight. That concern was underscored by the Federal Reserve’s most recent survey of loan officers, which on Monday showed that most domestic banks had tightened lending standards and that demand for loans had weakened in the second quarter. The pullback is compounded by a continued rise in interest rates despite the Fed’s efforts to grease the wheels of finance by gradually slashing its benchmark rate to 2 percent, down from 5.25 percent last August. The average interest rate on a 30-year fixed mortgage climbed to 6.7 percent last week, from 5.89 percent in the spring. “It appears that every time we peel away this onion, there is another layer,” said Curtis D. Ishii, the senior investment officer for fixed income at Calpers, the large California pension fund. He added that investors were starting to realize that the pain in the credit market would persist for some time. One measure of that stress is found in falling home prices. “To the extent that home prices keep spiraling down, the need for capital keeps increasing,” said Alejandro H. Aguilar, a portfolio manager at American Century Investments, the mutual fund company. Investors will be able to better estimate the size of their losses once it becomes clear how far prices will fall and when they will hit bottom. As they wait for the housing market to recover, many investors have continued to rush to safe havens like Treasuries and other debts with a government backing or a short payoff, a sign that investors remain unwilling to invest in mortgages, even though lending standards have improved from the go-go days of the housing boom. Money market funds, the short-term cash alternatives, grew to $2.9 trillion in June, up from $2.1 trillion a year ago, according to Crane Data. Those funds, in turn, have more than tripled their holdings of Treasuries and other government debt while reducing the share of their portfolios invested in somewhat riskier corporate notes. Patrick Ledford, chief investment officer at the Reserve, one of the nation’s largest operators of money market funds, said some institutional investors had moved assets into government funds from broader money market funds to avoid exposure to commercial paper, which are short-term debts. Some of the slack in the credit market has been taken up by the government chartered mortgage finance companies Fannie Mae, Freddie Mac and Ginnie Mae. The three firms have securitized $692 billion in home mortgages through June, putting them on track to match, approximately, the $1.2 trillion they securitized in 2007, according to Inside Mortgage Finance, a financial trade publication. But prices for these securities have fallen in the last two months, despite the backing of the government companies and initiatives by Congress and the Treasury to create a stronger government safety net for Fannie Mae and Freddie Mac. The two companies, which reported big losses last week, have said that they might reduce or slow the amount of large loans they buy from banks, a signal that two giants that had been big buyers might become sellers. If so, that would lower the price of mortgage securities even more, raising the cost of borrowing for home buyers. Because those developments have damped the private mortgage market, the Treasury Department has sought to revive activity by encouraging the use of covered bonds, which have been a popular investment in Europe. Unlike a mortgage security, the home loans that back a covered bond stay on the issuing bank’s balance sheet. If loans default, banks replace them, making the bonds less risky to investors but more so to the banks. In July, four big banks — Bank of America, Citigroup, JPMorgan Chase and Wells Fargo said they would issue covered bonds. But before jumping in wholesale, investors say they want to know more about the quality of loans backing the bonds and see more detailed federal rules about how the bonds will be handled if banks fail. “It may be a step in the right direction,” said Daniel O. Shackelford, a bond portfolio manager at T. Rowe Price, the mutual fund firm. “But I am not sure it will solve all the problems.” Some New York Loans Shunned Freddie Mac said Tuesday that it would stop buying subprime loans issued in New York State as a new law takes effect that holds investors accountable for mortgage fraud. Freddie will not buy loans dated on or after Sept. 1 that meet the state’s subprime definition, the government-chartered company said in a lender bulletin on its Web site. Gov. David A. Paterson of New York signed new foreclosure and lending laws last week that tighten legal protections for borrowers. The legislation holds mortgage buyers like Freddie liable in ways that “we have no way of monitoring and preventing,” Brad German, a company spokesman, said. The state law may disproportionately affect borrowers looking to use state and federal mortgage rescue programs to refinance out of unaffordable subprime loans, Mr. German said, but he said it would affect a “very, very small number” of loans. A spokeswoman for Governor Paterson, Erin Duggan, had no immediate comment.
They sold bonds causing price to fall and interest rates to rise.
“Traders drove a surge in interest rates because they feared inflation and a mounting federal budget deficit.” The reason traders sell bonds in the face of unexpected rising inflation, is because bonds have fixed coupon payment from the issuer (seller of bond) to the bondholder (buyer). Given higher than expected inflation, the real value of money decreases, hence the real value of the coupons decrease. This leads to people shorting bonds - supply outweighing demand and driving down bond prices, which leads yields to rise accordingly. Inflationary environments, (such as those driven by oil - you see a strong -ve correlation betwen oil price and the Dow).), people tend to invest in assets which retain value, such as gold - traditionally used to hedge inflation.
Yeah, if inflation goes up, or the demanded return on US Treasuries goes up, you only benefit from the higher rates if you have cash to buy at the new rates. If you have your money tied up in current FI instruments (assuming non-0 duration), you will continue to earn the rates you bought at, or perhaps a tiny bit more (because of reinvestment income). So if you expect inflation to happen, you need to sell your bonds right away so you can repurchase them when rates are higher. If lots of people are selling at the same time, the price drops, and that in itself results in higher yields.
right and a budget deficit means (obviously) that govt spending is outpacing tax revenues, necessitating increased govt borrowing (i.e. Treasury issuance). heavy supply is a negative technical for the bond market, all else equal.