Influences Of The Yield Curve On The Equity And Commodity Markets

``The interest rates for more distant maturities are normally higher the further out in time. Why? First, because lenders fear a depreciating monetary unit: price inflation. To compensate themselves for this expected (normal) falling purchasing power, they demand a higher return. Second, the risk of default increases the longer the debt has to mature.-Gary North

The first structural factor, the record steep yield curve, should be a familiar theme to those who regularly read my outlook.

This accounts for as the “profit spread” from which various institutions take advantage of the “borrow short term and lend or invest in long term assets”[1].

The Yield Curve (YC) is a very dependable tool for measuring boom bust cycles (see figure 2).

That’s because artificially lowered interest rates, a form of price control applied to time preferences of the individuals relative to the use of money, creates extraordinary demand for credit and fosters systematic malinvestments or broad based misdirection of resources within markets and the economies.

Figure 2: Economagic.com: Yield Curve and the Boom Bust Cycle in the S&P 500

Sins Of Omission: The Influences of Habit or Addiction

It’s fundamentally misplaced to also conclude that just because balance sheet problems exist for many consumers, particularly for developed economies in the West, as they’ve been hocked up to their eyeballs on debt, that they would inhibit themselves from taking up further credit to spend. This also applies to some corporations.

Such presumption fatally ignores individual human action, particularly, for people to develop and sustain irrational habits. Some of these habits grow to the extent of addiction, which could have a beneficial (reading) or negative or neutral effect (mowing lawns). Albeit, addiction has a predominantly negative connotation.

While addiction[2] has many alleged modal causes, e.g. disease, genetic, experimental, and etc., some models have been argued on the basis of purely psychology, specifically:

-choice [The free-will model or "life-process model" proposed by Thomas Szasz],

-pleasure [an emotional fixation (sentiment) acquired through learning, which intermittently or continually expresses itself in purposeful, stereotyped behavior with the character and force of a natural drive, aiming at a specific pleasure or the avoidance of a specific discomfort."- Nils Bejerot]

-culture [“recognizes that the influence of culture is a strong determinant of whether or not individuals fall prey to certain addictions”]

-moral [result of human weakness, and are defects of character]

-rational addiction [as specific kinds of rational, forward-looking, optimal consumption plans. In other words, addiction is perceived as a rational response to individual and/or environmental factors. There wouldn’t be an addict or substance abuse problem, if those affected are disciplined enough to correct habit abuses.]

If affected persons, in recognition of such problems, simply applied self-medication or took preventive measures to avoid the worsening development of negative addiction, then obviously we wouldn’t have addiction problems at all! But certainly this hasn’t been true.

From a psychological standpoint, it would seem quite apparent that addiction is largely a stimulus response feedback mechanism or very much a behavioural predicament.

In other words, negative addiction is fundamentally a choice between temporal happiness over future consequences (frequently adversarial outcomes) or where habit interplays with choices, rational alternatives, environment, moral frailty, cultural influences or seductiveness of pleasure vis-a-vis normal behaviour.

Simply put, there is an incentive for people to develop different forms of addictions.

Applied to the markets or the economy, what if the source of profligacy [or Oniomania[3] or compulsive shopping or compulsive buying], a form of addiction, stems from government initiatives, by virtue of artificially suppressed interest rates?

And what if government induces people to spend on things they can’t afford with money they don’t have, out of the desire to fulfil economic ideology or to promote certain industries?

Will the teetotaller refuse government’s offer of free drinks?

How much of government induced behaviour from reckless policies will force individuals and businesses to take the low interest rate bait?

And this seems to be the story behind the yield curve.

The Stock Market And The Yield Curve Over The Long Term

Notice that every time the long term yield (30 year treasury constant maturity-red) materially diverges from the short term yield (1 year treasury constant maturity-blue) to form a steepened yield curve (black arrow pointed upwards), the S&P 500 (green) blossomed.

On the other hand, inverted yield curves, where short term yields had been higher than the long term yields (green arrow pointed downwards), had preceded recessions and severe market corrections.

Like normal yield curves, the yield curve’s impact on the economy has a time lag, a 2-3 year period.

Even the October 1987 Black Monday crash appear to have been foreshadowed by an account of relatively short inversion in 1986.

And the inflation spiral of the late 70s saw short term rates race ahead of short term rates for an extended period.

So why does an inverted yield curve occur?

Because the debt markets reveal the amount or degree of misallocations in the market ahead of the economy.

According to Professor Gary North

``This: the expected end of a period of high monetary inflation by the central bank, which had lowered short-term interest rates because of a greater supply of newly created funds to borrow.

``This monetary inflation has misallocated capital: business expansion that was not justified by the actual supply of loanable capital (savings), but which businessmen thought was justified because of the artificially low rate of interest (central bank money). Now the truth becomes apparent in the debt markets. Businesses will have to cut back on their expansion because of rising short-term rates: a liquidity shortage. They will begin to sustain losses. The yield curve therefore inverts in advance.”[4]

This means that when consumers and businesses compete for short term funds, demand for short term money raises interest rates. Nevertheless, as the fear of inflation recedes, “an ever-lower inflation premium”[5] forces down long term yields.

As a caveat, since corporations operate on the principle of a profit and loss outcome, they’re supposedly more cautious. But this hasn’t always been the case. And it should be a reminder that a fallout from an imploding bubble does not spare so-called blue-chips, as in the case of the US investment banking industry, which virtually evaporated from the face of earth in 2008.

Industries that have been functioned as ground zero for bubbles are usually the best and worst performers, depending on the state of the bubble.

Figure 2: Business Insider: Falling Net Debt To Cap

Figure 2 is an interesting chart.

Interesting because the chart shows of the long term trend of the S & P 500 Net debt to Market cap-which has been on a downtrend, for both the overall index (red spotted line) and the ex-financials (blue solid line).

Since it is a ratio, it could mean two things: debt take up has been has been falling or market cap has been growing more than debt. My suspicion is that this has been more of the growth in market cap than of debt (since this is a hunch more than premised on data, due to time constraints, I maybe wrong).

In addition, since the tech bubble, corporate debt hasn’t grown to the former levels in spite of the antecedent boom phase prior to the crash of 2008.

Nevertheless, the substantially reduced leverage from corporations, particularly the net debt (red spotted line) which has reached the 2005 low, suggest of a recovery. This could signify a belated play on the yield curve.

Prior to the recent crisis, the S&P net debt began to recover at the culminating phase of the steep yield curve cycle.

Could we be seeing the same pattern playout?

Commodities And The Yield Curve

Finally, the link of the yield curve relative to US dollar priced commodities has not been entirely convincing. (see figure 3)

Figure 3: Economagic: Yield Curve and the Precious Metals

Over the span of 3 decades, we hardly see an impeccable or at least consistent correlation.

Precious metals in the new millennium soared during the steep yield curve. But it also ascended but at much subdued pace during the inversion.

In the late 70s precious metals exploded even during inverted yield curve. While it may be arguable this has been out of fear, it does not fully explain why gold and the S & P moved in tandem see figure 4.

Figure 4: Economagic: Precious metals and the S&P 500

Moreover, between the 80s and the new millennium, correlations have been amorphous.

And perhaps as we earlier averred this could have been due to the formative phase of globalization where much of liquidity provided by the US Federal Reserve had been “soaked up” by the inclusion of China and India and other emerging markets in global trade as a result of policies from Reaganism and Thatcherism and the collapse of the Soviet Union.[6]

The various bubbles around the globe, during the said period, serve as circumstantial evidence of the core-to-the-periphery dynamics.

Overall, as the yield curve remains steep, we believe that the upward thrust of markets should continue to hold sway as the public will be induced to take advantage of the “profit spread” as well as with central banks continued provision of stimulus conditions that would revive the compulsive manic behaviour seen in persons afflicted by varied forms of addiction.

---

[1] See Does Falling Gold Prices Put An End To The Global Liquidity Story? and Why The Presidential Elections Will Have Little Impact On Philippine Markets

[2] Wikipedia.org, Addiction

[3] Wikipedia.org Oniomania

[4] North, Gary; The Yield Curve: The Best Recession Forecasting Tool

[5] North, Gary; When the Yield Curve Flips. . . .

[6] See Gold: An Unreliable Inflation Hedge?

The Yield Curve Takes Control: Philippine CPI Increases to 1.3% in November

There are two kinds of statistics, the kind you look up and the kind you make up—Rex Stout from Death of a Doxy

The Yield Curve Takes Control: Philippine CPI Increases to 1.3% in November

The Forecasting Prowess of the Yield Curve; the CPI Cycle

The yield curve of the Treasury Markets, as I have been saying, presages statistical inflation. 

 

On the left of this chart is the 2012 based Consumer Price Index (CPI). On the right is the yield differential of the 10-year T-bond and the 1-year T-bill, as well as, the variance between the 1-year T-Bill and the CPI or the real yield.

The spread of the 10- and the 1-year curve has accurately foretold the direction of the 2012 CPI since the latter came to replace its 2006 predecessor in 2013.

The curve began to flatten ahead of the CPI in 2013 before the BSP raised rates in 2014. It commenced on steepening in 3Q 2015, a few months before the BSP opened the QE floodgates, pushing the CPI to reach a climax in 3Q 2018. The curve started to flatten anew before the BSP hurriedly raised policy rates beginning the 2Q 2018, whereby the CPI soon followed with a plunge. The flattening morphed into an inversion, a sign of extraordinary financial tightening, antecedent to the BSP’s chopping of policy rates, which started in the 2Q 2019. Such yield curve inversion, the first since at least 2000, is an indicator of heightened risks of a recession.   

The history of the BSP’s monetary policies can be found here.

Not only the CPI cycle, but the Philippine treasury yield curve seems to have even been predicting the crucial shift in BSP’s policy trends!

But the soothsaying prowess of the yield curve can be seen in a different light.

The yield curve, instead, projects the incumbent policies of the BSP, which drives the CPI cycle. And once the curve reaches a certain point from which the CPI follows with a time lag, treasury investors foresee and prices a turnaround on the BSP policies in response to such dynamic. The yield curve’s inflection points, thereby, represent the treasury market’s anticipation of the denouements of the peak and troughs of the CPI cycle.

Here is a truncated backstory.

In response to the tightening by the BSP in 2014, the CPI downshifted, after peaking in August 2014, for 14 straight months until it recorded two months of deflation in September and October 2015. The sharp and speedy decline of the CPI prompted the flattening dynamic of the curve to reverse in July 2015, reflecting the Treasury market’s expectation of the revival of the CPI from the BSP’s easing.

The BSP’s tightening process indeed ended with the opening of the QE spigot in the 4Q of 2015. This financial easing was supported by the record drop in its policy rates, which was implemented by the BSP in June 2016, presented under the camouflage of the adaption of the Interest Rate Corridor (IRC) System.

The yield curve steepened until it climaxed in January 2018, and four months later, in response to the surging CPI, the BSP began its 175 bps series of hikes implemented within 7-months. The CPI, meanwhile, hit a multi-year high of 6.7% in September 2018, 8-months after the curve began to flatten.

That January 2018 flattening cycle culminated with an inverted yield curve in March 2019, which from this milepost has sharply steepened to manifest the Treasury markets’ expectations of a resurgent CPI.

The BSP responded to the liquidity squeeze with a series of rate cuts, totaling 75 bps thus far, which started in May 2019, as anticipated by the curve. RRR cuts of 400 bps had also been used to ease financial tightness.

Nevertheless, because of radical political responses to the 2018 rice crisis, and statistical anomalies, if not skullduggery, the headline CPI still plunged to a 42-month low last October.

And because of the tenacious widening of the curve, which has clashed with the artificially depressed statistical inflation, confronted with a credibility dilemma, the National Government relented to publish a higher CPI last November.

Action Speak Louder than Words: Economists See No Inflation, Traders Price in Higher Inflation

 

The Philippine capital markets have a very thin participation rate from the general population. Like the stock market, the treasury market has been dominated by the financial institutions and also government financial institutions. But unlike the stock market, foreign participation may not be as significant. [Nota Bene: I’m sorry. I have no access to latest data, except to rely on old reports. Example in 2011, non-residents account for 10% share of local government bond]

As the Asian Bond Online reported in its 3Q 2019 Asian Bond Monitor: “Banks and investment houses remained the largest investor group in the Philippine LCY government bond market in Q3 2019, with an investment share slightly rising to 42.6% at the end of September from 41.9% a year earlier. Contractual savings institutions (including the Social Security System, Government Service Insurance System, Pag-IBIG, and life insurance companies) and tax-exempt institution (such as trusts and other tax-exempt entities) were the second-largest holders of government bonds. However, their share fell to 23.9% from 27.2% during the same period. The share of brokers and custodians was almost at par at 11.5% during the review period, while that of funds managed by the BTr inched up to 10.0% from 9.4%”

The treasury markets reveal the demonstrated preferences of the institutional participants or ‘action speaks louder than words’. What in-house economists and experts from financial institutions say has starkly been different compared with what their treasury departments do. Experts tell media that CPI should remain muted, but paradoxically, traders of treasury departments from these establishments don’t believe what their analysts have been saying!

And from this view, traders from various treasury departments have some indirect influence on the BSP’s policies.

November CPI Expands to 1.3% as Divergences Persist

The Philippine Statistics Authority reported that a jump in November’s CPI to 1.3%.

Curiously, despite the sustained significant deflation in the rice (-8.3%) and bread (-2.2%) CPI (-5.6%), which led to a slight -.2% deflation in Food CPI, the headline CPI still climbed! Add to this the irony of deflation in Transport CPI (-2.4%). The previous drivers of the suppressed CPI have failed to influence more downside on the headline!

What segments pushed the higher the CPI in November? According to the BSP: “The uptick in November headline inflation rate was traced mainly to higher prices of selected food items. Inflation rates for meat, fish, vegetables, as well as milk, cheese, and eggs increased in November compared to year-ago levels. At the same time, year-on-year inflation rates for rice, corn, as well as sugar, jam, honey, chocolate, and other confectionery were also less negative during the month. Meanwhile, year-on-year non-food inflation was unchanged in November as higher actual rentals for housing and upward adjustments in electricity rates due to the increase in generation charge were offset by the lower transport inflation during the month.”

As the headline inflation rose, the Core CPI slipped, the result of which has been to diminish the record divergence. Pls. see my past explanations.

[see 3Q CPI Fall to 42-Month Low as Divergences in Component CPIs Widen; Flawed CPI—the Shakey’s Pizza Evidence November 10, 2019

or here

Headline CPI at 40-month Low Diverges with the CORE; Plummeting M2’s Savings Deposits Should Spur the BSP to Relaunch QE Soon October 13, 2019]

 

The headline CPI’s November advance has been a product of the increases in its subsectors, particularly, alcohol (+17.6%), household utilities (+1.2%), furnishings (+2.8%), health (+3.1%) and communication (+.3%) relative to the previous month.

However, the bizarre disconnect between the food CPI and the restaurant CPI persisted in November. 

 

While the food CPI was less deflationary (-.2%), restaurant CPI (+2.7%) was unchanged. Hence, the record spread had narrowed slightly.  

Such statistics tell us that consumers exist in a vacuum. Consumption of food at home and food at restaurants has little human and economic connection between them.

These statistics have little relevance to the real world.

Steepening Global Yield Curve Reflects Thriving Bubble Cycle

``The way out of a deflationary trap is to first induce inflation and then to reduce it. That is an intricate operation and success is far from assured. As soon as economic activity in the United States revives, interest rates on government bonds are liable to shoot up; indeed, the yield curve is likely to steepen in anticipation. Either way, a rise in long-term interest rates is liable to choke off the recovery. The prospect of the greatly increased money supply turning into inflation is likely to lead to a period of stagflation. That, however, would be a high-class, desirable outcome because it would avoid prolonged depression.” George Soros, My Outlook for 2009

The overwhelming performance of today’s stock markets and commodity markets has sent a few bears “capitulating”. The stunning surges in the markets has had powerful psychological leash that has been proselytizing much of the “consensus” to interpret for a “strong” economic recovery.

This clearly has been a manifestation of the operational aspects of the reflexivity theory feedback loop-where people interpret price signals as signifying real events, and where real events reinforce the price signals.

For mainstream analysts, the “animal spirits” have been roaring back to life!

For us, the present phenomenon have been reflecting the escalating symptoms of the influences of monetary forces over the markets and the real economy, which is another way of saying-we are witnessing anew serial bubble blowing dynamics at work which is being fueled by policy induced inflationary forces.

Upward Sloping Global Yield Curve Drives Maturity Mismatches

Notably steeping yield dynamics has been part of the bubble blowing framework, see figure 1.

Figure 1: BCA Research: Global Yield Curve Strategy

The independent Canadian Research outfit BCA Research believes that it would take central banks at least the 2^nd half of 2010 for the policymakers to begin raising rates thereby flattening the yield curve or the ``relation between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given currency.” (wikipedia.org)

According to the BCA, ``During the last recession, the 2/10 Treasury slope peaked in August 2003 but did not begin to steadily flatten until early 2004, a few months before the Fed began its tightening campaign in June of that year. Last week, Atlanta Federal Reserve Bank President Dennis Lockhart outlined the unusual scenario that if faced with inflation, the Fed could potentially increase the target funds rate even as it continued to pursue quantitative easing. Although technically possible, thanks to the recent policy of paying interest on bank reserves, this outcome is highly unlikely. Rate hikes will be politically impossible in the near term. It would be far easier to gradually and quietly unwind monetary stimulus in the reverse order that it was implemented, i.e. by selling long-term securities. Bottom line: Government yield curves are at cyclical extremes but a material flattening phase may still take until late 2009 or early 2010.” (bold highlight mine)

This would be an example of looking at similar data sets but with divergent interpretations.

Notice that during the dotcom bust at the advent of the new millennium, produced a steepening of the global yield curve which coincided with the incipient boom in the US real estate industry (green circle).

Further notice of BCA’s observation that “the 2/10 Treasury slope peaked in August 2003 but did not begin to steadily flatten until early 2004”- eventually paved way for the real estate bust which emerged in 2006 albeit more than a year later, whereas the bearmarket in stocks finally surfaced in 2007 about a year after the cracks in the US real estate industry became unstoppable force.

Why is this?

Because, according to Professor Philipp Bagus and David Howden, ``maturity mismatching can turn out to be a very profitable business, involving a basic interest arbitrage. Normally, long-term interest rates are higher than their corresponding short-term rates. A bank may then profit the difference — the spread between short- and long-term rates — through these transactions. Yet, while maturity mismatching can turn out to be profitable, it is very risky as the short-term debts require continual reinvestment (i.e., a continual "rollover" must occur).” (bold highlights mine)

In other words, the widening yields spread greatly benefits banks which aside from profiting from maturity mismatch arbitrage also provide funding that fuels the speculative “animal spirits” in the marketplace through the “borrow short and lend/invest long” or the basic framework for what is popularly known as the “carry trade”.

And the ensuing risks emanates from the burgeoning mismatches of assets and liabilities, the liquidity and rollover risks. Why? Because according to Professor Jeffrey Herbener, ``The swollen liabilities of checkable deposits are payable on demand to customers while the matching assets of loans are not recoverable on demand by banks. Profits earned by entrepreneurs no longer correspondent completely to the satisfaction of consumer preferences, but are systematically distorted by the artificial spending stream fed by the central bank. Entrepreneurs are misled by the credit expansion into shifting the use of factors into activities considered less-valuable by consumers.” (bold highlights mine)

Borrowing short and investing long needs constant liquidity infusion because long term investments like real estate can’t be monetized soon enough in the same manner as placements in money market funds. And where a sustained episode of liquidity shortage surfaces, trades founded on this platform ultimately collapses. This had been one of the major hallmarks of the financial crisis of 2007.

But we seem to be presently seeing the resurrection of a similar edifice.

I would like to further add that present policies which induce speculative bubbles don’t generate ‘productivity gains’ that’s because the “artificial spending stream” have been causing entrepreneurs to misallocate or engage in malinvestments.

Moreover, speculating in the marketplace don’t generate net jobs as jobs added are those from the financing side (e.g. brokers, investment houses etc.) at the expense of “unseen” investment and jobs lost serving consumers.

And importantly, once the yield curve flattens or reverses to negative, capital instead of accumulating would be lost, as the unsustainable bubble structure would be eviscerated! In 2008, ADB estimates financial assets losses at $50 trillion (Bloomberg)!

Philippine Yield Curve Reflects Global Direction

Figure 2: Asian Bonds Online: Philippine Benchmark Yield Curve

The elevated slope of the yield curve also applies to the Philippine setting see figure 2.

Remember, the Philippine private sector is largely little leveraged on both absolute and relative levels (compared to Asia).

Hence, when our Central Bank officials as BSP deputy governor Diwa Guinigundo say ``Having the scope for higher savings does not mean of course that we should discourage consumption expenditure in the economy…Consumption sustains higher level of economic activity,” we should expect a boom in credit take up to occur as policies shapes the public’s incentives.

So you can expect domestic bankers and financers to knock on your door and, to paraphrase Mark Twain, lend you their umbrella (offer you generous loans or credit) when the sun is shining (as markets appear to be booming), but eventually would want it back the minute it begins to rain (crisis).

Rest assured present policies will foster persistent expansion of “circulation credit” that should benefit the Philippine Stock Exchange (PSE) and the Phisix over the interim and the present cycle.

Yield Curve Could Steepen Further, “Benign” Inflation

We agree with the BCA when they suggested that ``Rate hikes will be politically impossible in the near term.” That’s because the economic ideology espoused by Central Bankers and mainstream analysts essentially ensures the continuation of asset supportive policies.

More than that, as Emerging Market (EM) economies begins to experience a cyclical “boom” EM central banks will likely continue to add on US dollar reserves, which most likely will be recycled into US treasuries. The BRICs or the major emerging markets of Brazil, Russia, India and China reported the fastest pace of US dollar buying worth-$60 billion of US dollar reserves in May (Bloomberg).

US dollar purchases by Asia and Emerging markets will likely be sustained for political goals, but the composition of purchases has been substantially changing. This most likely reflects on EM central bankers concerns over US policies, as EM officials have been openly saying so.

Meanwhile the concentration of official purchases has markedly weaned away from agencies with diminishing exposure on long term securities (T- bonds) and has apparently been shifting into short term bills.

Yet if the present direction of US treasury acquisitions persists, then the short end of the yield curve will likely remain supported and probably won’t rise as fast as the longer term maturity.

Figure 3: Northern Trust: Rising Treasury Yields versus Falling Private Security Yields

On the other hand, yields of US treasury bonds have been rising perhaps mostly due to “expectations” on economic recovery as private sector credit spreads has meaningfully declined, see figure 3.

Northern Trust chief economist Paul Kasriel explains, ``If the current and increased supply of Treasury debt coming to market were “crowding out” private debt issuance, then the yields on privately-issued debt would be holding steady or rising in tandem with the rise in the Treasury bond yield. But again, yields on privately-issued debt are falling. In sum, investor risk appetite is returning, which is a good thing for the prospects of an economic recovery, not a bad thing.”

And last week’s 30 year bond auctions successfully drew up a good number of buyers. Despite higher yields (since August of 2007) the bid to cover and number of indirect buyers (possibly foreign central banks) saw significant improvements (Bloomberg).

So maybe, for now, markets appear pricing in a US economic recovery as the credit markets, stock markets and commodity markets, the Volatility or Fear Index and Credit Default Swaps on sovereigns debts have all been in confluence to reveal signs of dramatic improvements over the marketplace.

As my favorite foreign client recently observed, this is could be the benign phase of inflation.

Nevertheless in congruence with the observation of the BCA Research, it seems that the yield curve for US sovereign securities could remain in an upward sloping direction even if it has already been drifting at the cyclical extremes. The massive funding requirements by the US government (estimated at $2 trillion for 2009 out of the $3 trillion estimated for the world) for its deficit spending programs ensure higher yields for the longer maturity sovereigns. This combined with US official policy rates at zero interest levels and emerging market central banks purchases on the shorter end.

And we could expect the slope of the global yield curve to track the direction of the US but perhaps at a much subdued scale as debt issuance compete with limited global capital.

So as long as the yield spreads continues to widen, we should expect the fury of monetary “speculative” forces nurtured by the global central banks to be vented on the global stock markets and commodity markets.

The Current Dramatic Flattening of the Philippine Yield Curve Means Risk Ahead!

I’m not making any formal writing anymore until 2015.

Anyway here is the weekend update of the Philippine yield curve.

The above represents the entire yield curve based on Friday’s quote for the past 6 weeks. 

As one would note, the short end of the curve has been rapidly ascending relative to the long end. This means that the domestic yield curve has been dramatic flattening.

A better expression of the curve would be the spread between the long end and the short end, where I compare the yields of 10 and 20 year minus the 1 year.

Again a dramatic flattening has been in place for the past 6 weeks for either the 10 or the 20 year curves.

There are two ways to look at this. First, why has there been a sharp rise in the short end?

The second is what are the implications?

I offer an answer to the WHY.

The fundamental premise is that current highly leveraged firms or institutions who have been starved of cash could be desperately borrowing at higher rates to fund operational financing gaps in order to maintain current projects or positions. And this applies to both stock market speculators/market manipulators and entities which mostly belong to the bubble industries.

Remember, Philippine treasuries essentially represent a tightly held or controlled markets by the government and the domestic banking system (see above from ADB’s November Bond Monitor at ASIAN Bonds Online). 

As argued before, this is why both have used the bond markets to drive down rates towards a convergence with US treasury yields. I called this the “convergence trade”. 

Financial repression policies led to the corralling of resources of depositors enrolled in the formal banks through zero bound rates. Most importantly, such invisible transfer also covered the currency holders or mostly the informal economy.

Thus, these policies represented subsidies to both banks (and their clients) and the government at the expense of the average resident.

This has been a wonderful example of what inflationism does: By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. (JMKeynes)

Resources, intermediated by the banking system, have been funneled to the real economy via a “pump” on bubble industries to mostly firms of elites where G-R-O-W-T-H happened. 

The subsidy to the banks and their clients inflated tax revenues that bankrolled ballooning government spending, thus an indirect subsidy to government. 

Additionally by repressing interest rates, maintaining government liabilities had been below market rates. Thus the two-pronged subsidies in favor of the government.

The above represents the insatiable spending appetite by the Philippine government as exhibited by the 2015 budget, which was recently passed. 

The second chart signifies the historical revenues, expenditures and deficits as of 2013. 

Despite the boom deficits continue, wait until the slowdown occurs and deficits and public debt will swell!

There is a third non-financial or political benefit: high public approval ratings. This allows the incumbent to impose more populist political whims.

Just think of all the recent colossal bond issuance from major companies that practically returned nearly zero (or even negative) to investors, net of inflation and taxes. Those surreptitious transfers not only meant free money for banks, bubble industries and the government, they also translated to a massive transfer of risk.

This implies that a substantial segment of depositor’s resources have now been exposed to various risk factors: interest rate, market, and credit. For foreign based loans, currency risks.

In a nutshell, for any strains in Philippine treasuries to emerge means that some formal economy institutions, perhaps in the financial sector, have already been feeling pressures.

So despite all the hallelujahs from government statistics, the bond market has been implying of developing cracks in the credit driven phony boom.

I also wrote of the possible implications: higher short term financing costs, a symptom of liquidity squeeze and could even signify seminal indications of a developing credit crunch!

Yet there is more: pressure on banking system’s balance sheets.

A flattening yield curve discourages borrowing short and lending long or the maturity transformation or profits from asset-liability mismatch arbitrages. A flattening of the yield curve may squeeze on interest rate margins. This means that credit expansion will slow or at worst, could even grind to a halt.

Since the Philippine G-R-O-W-T-H story has been one pillared by credit expansion (as previously discussed), any slowing of the credit boom extrapolates to a slowdown in statistical G-R-O-W-T-H.

And as the credit expansion fades, credit risk rises. If statistical G-R-O-W-T-H slows where will levered firms get money to pay for newly acquired loans? Here’s a guess: by borrowing more.

This could already be happening which is why short term bond yields have spiked.

Look at the Philippine banking system’s income statement from BSP data. Domestic banks are heavily dependent on interest rate income which accounts for about 2/3 of the banking system’s income. 

A flattening of the yield curve may likely put a squeeze on domestic bank’s interest rate margins. So slowing credit growth and prospective decline in interest income will eventually hurt bank’s profits.

Additionally even if we are to look at the banking system’s non –interest income; fees and commissions almost accounts for half. So the banking system’s non-interest income indirectly depends on the sustained G-R-O-W-T-H in bubble industries and in asset markets (specifically stock markets) which ironically depends on credit growth!

So the yield curve says that credit growth will slow, thereby affecting G-R-O-W-T-H and increasing risks of banking system’s loan portfolio which accounts for half of banking system’s total assets!

Take away the illusions from credit growth, the entire house of cards crumbles

So unless there will be material improvements in the yield curve soon, the one way trade mentality held by the consensus will get another sting!

But if the yield curve continues to materially flatten or even exhibit inversion, then big big big trouble lies ahead.

Don’t worry be happy. Perhaps when economic Typhoon Yolanda arrives, affected banks may be bailed out  by the government financed by the average citizenry through higher taxes and inflations. So stocks will rise forever!

But as the great Austrian economist Ludwig von Mises warned

But the boom cannot continue indefinitely. There are two alternatives. Either the banks continue the credit expansion without restriction and thus cause constantly mounting price increases and an ever-growing orgy of speculation, which, as in all other cases of unlimited inflation, ends in a “crack-up boom” and in a collapse of the money and credit system. Or the banks stop before this point is reached, voluntarily renounce further credit expansion and thus bring about the crisis. The depression follows in both instances.

Have a great weekend!