Five percent that changed the world

How much is it 5%? It’s relative. Have we had 1000 dollars that would be fifty bucks. On equity or commodity markets that would be juicy profit or loss. As a margin for goods manufacturing entity – that is dependable on type of goods and costs occurred – as it will directly impact our EBITDA. On more volatile markets like crypto, that would be just another boring day. But on treasury markets - especially in relation to yield – five percent mean a lot.

---

Despair in decline

Long-term decline of yield on government bonds has ended in recent years. Sharp correction of 2020 eventually turned into growths. Yield on bonds left technical long-term declining chanel at the beginnings of 2022 and continued moving upwards. Bonds just recently reached 5% but have been pulled back and now oscillate at – US10Y at 4.64% and US30Y at 4.81%. In addition, spread between these two had shrank. This indicate that investors are concerned about near to mid term future. Some could say, that having two wars (Ukraine and Gaza) and geopolitical tensions in other regions of our planet should trigger great need for security assets – like bonds. Problem lies in the fact that trust in overall securities somehow diminished due to variety of reasons. As in recent months, or should we rather say - last two years, securities brought double-digit losses.

---

Just after November decision on rates in USA, stocks rallied and short-term bonds had fallen on yields. With low expectation on further rate hikes from Fed, and possible plateauing until end of H1 beginning of H2 2024, recession expectations gathered momentum. Fed also suggests two rate cuts in 2024. In addition readings on US economy showed relative weakness, which also contributed to rally in value of bond (yield had dropped). This of course effects in recent sharp drop on DXY, which is dollar strength index measured against basket of main currencies. Lows at 104.6 had been quickly partially negated by Monday opening and even stronger Tuesday. In the moment of writing these words (7th November 2023), DXY stands at 105.1 points. On the other hand, principles of US fiscal policy remained unchanged. USA plans to issue even more debt in current fiscal year. In addition, its tax revenue has chances to fall sharply due to variety of tax incentives for strategic sectors.

Said 5% on US bonds marks an important level. It has not been seen since 2007, which was very dawn of financial crisis. It also bears also psychological significance, as our minds developed on traditional mathematics, perceive full numbers as important. On this occasion we’re also on resistance levels, where potential passing through 5-5.50% may bring another stop at 6.50%. Is it possible for such scenario to occur? Another question is if institutions are ready for such development. After all, high yield means, market value of bond they have among assets falls sharply. Earlier this year we commented on subject of falling banks in our analysis ‘Lagging price action? On the occasion of falling banks and gold attacking 2k USD’. Now it seems that another local bank in USA had fallen, which was Citizens Bank from Iowa. In addition, word on the markets is, that Bank of America may suffer on certain liquidity issues. Of 400 bn market cap from late 2021, currently it stands at 223 bn. And it’s not just a bank, it is one of the Prime Dealers and one of the main ingredients of US banking system.

So, on this occasion we believe it is time to discuss debt papers. Especially, that since early 2022 we experienced breaking of 20 years lasting correlation in between inverted 10Y treasury yield and a price of gold. In normal circumstances gold value of the bonds did act in opposition – bonds were strengthening (yield was falling) and gold was down. And of course this affected USD. Nowadays this correlation is no more, and it seems many value any possible safe haven assets.

---

What are bonds, securities, treasuries and IoU

We already discussed relation of treasury papers and gold already in our analysis several times. But we remain under impression that all this was spread in between analysis. Correlations in one, role in the other, importance in another. Seems it is time to wrap that up for good in one solid text.

Bond / Treasury is a security issued in a series in which the issuer states, that it owes a debt to the bondholder and pledges to provide to him specific monetary or non-monetary benefit. In other words – IoU – I Owe U, and promise to pay back what you had lend me, at a certain agreed time and with agreed interests in form of money or other bonuses we agreed upon. Bonds could be emitted by country but also entity, like bank, municipality or corporate entity. There are certain strict legislation requirements to be met upon these cases, which for obvious reasons local treasury departments do not have to meet. IoU are issued in a series, they represent property rights divided into a specified number equal units.

Each bond is a unique security. Upon purchase we have to consider certain aspects related to:

• Who made an emission - some issuing bodies seem to be more reliable than the others.
• Maturity date – when issuer pledges to buy it back from us, paying full face value.
• Nominal / face value – how much do we pay for said securities.
• Market value / price – how much market will pay us i.e. today had we decided to sell securities we own before maturity.
• Yield – this is basically interests we’ll earn yearly until IoU’s maturity.
• Currency emission – bonds may be issued in currency different than issuer’s to attract buyers. Hence fx risk is applicable.

These are the most basic terms, and we do not even attempt to discuss other related market indicators like yield to maturity, Macaulay duration, modified duration, yield curve, yield to maturity in terms of risk, what bond spreads indicate and many more used to measure if our investment makes us wealthier or just opposite.

Variety of securities is immense. They may be issued as unsecured, asset-backed (like mortgage-backed, equipment-backed, collateral). Its yield may be fixed, floating, inverse floating or zero-coupon. Some may rank claims of more senior buyers above other (subordinated – junior/senior). And some give even right to loaner to force issuer to re-purchase them before maturity (callable, putable and refundable). Naming securities depends of maturity, where short-term (up to 1 years) are being referred as ‘bills’, midterm (2, 3, 5, 7 and 10 years) are being called ‘notes’, and these with maturity extended in time (20 or 30 years) are being referred as ‘bonds’. Above nomenclature is based on US terminology, and may differ locally on markets. To make it simpler we’ll be referring all of them exchangeable as securities, treasuries, bonds and IoU’s and if needed, will simply add maturity in name.

On a side note to variety of types - there are even perpetual bonds, although they remain niche. They do not have maturity date, simply paying yield for eternity. Like world’s oldest bond in existence had been released in Netherlands in 1624, issued with purpose to gather funds to fix damaged dyke - still pays 2.5% interest. Due to inflation, currency changes and history of Netherlands, that would be 15 EUR per year.

---

Let’s invoke another extremal yet modern example – Austrian 100Y. A century seems to be quite a time, isn’t it? Silly to assume that in monetary system based on growth of monetary base and inflation being under or out of control, our descendants would be able to sell it on market before maturity with gains However there are some countries that decided to issue 50Y bonds. Even USA at some point probed markets toward this direction. Austrian 100Y had been issued in 2017 with yield 2.1% were deemed great investment and had been sold immediately. Then they had been re-issued in 2019, now with price at 150% nominal value and yield 1.1%. And another series had been issued again during hot year 2020. Its price had grown at some point to 230% of nominal with yield at 0.4%. Hence very initial investors and speculators were well awarded. Nowadays its nominal price had fallen to 33 EUR – staggering 67% decline on nominal value and even more if considering heights, with yield flirting currently with 3% level in inflationary environment expected for 2023 in Austria at 7.84%.

---

It is government bonds considered by financial markets as safest of the safest. Of government bonds these are US bonds considered as crown jewels. That is because US issued IoU’s carry the full backing of the US government and they are (or were?) viewed as one of the safest form of investment. ‘Or were’? Do we dare to undermine authority of US government? No, just you can now more often find bonds issued by corporate entities that pay better yield than US treasuries. Precious metals miner – Newmont Mining – as such example, proposes 6.25%.

Of all US issued bonds, that would be 10Y and its yield being closely watched as an indicator of broader investor confidence. Considered as one of the lowest-risk investments ‘made in USA’, delivering fixed-income, 10Y are ‘risk-free’ benchmark against which other investments and debt are compared. And 10Y is being used as a barometer or proxy for economic factors, including investor sentiment and mortgage rates.

How does it works in simplified practice? Government funds growing part of its fiscal needs by treasury emission via Treasury Department. Treasury on the other hand uses Federal Reserve as intermittent and proxy. Federal Reserve itself is being divided between 12 districts. Apart of acting locally, some have also more specialised roles. St. Louis Fed excels in statistical information, but for treasuries, we have to focus on NY Fed who acts as a modern and historical US window to the world. That shouldn’t surprise, considering New York was financial centre of USA already in 19th century and now is considered as a financial centre of the world.

Federal Reserve doesn’t distribute government IoU’s by itself – it has people to do it instead. Upon debt issuance Prime Dealers participate in its auctions. Primary Dealers are private institutions that are also partners of NY Fed in open market operations, i.e. the implementation of monetary policy. These institutions are also authorised by the Fed to buy government bonds straight from the source. Being one of them has its benefits but also responsibilities. They are expected to participate proportionally in all auctions of government bonds, which are to be purchased at ‘reasonably competitive prices’. They can do whatever they want with the bonds they purchased and most often sell them on secondary markets, for clients around the world. Yet, by virtue of being participants in the prime market, they become part of the monetisation process, where central bank converts equivalence of debt into the equivalence of the currency now injected into circulation. And another side note – recently departed Credit Suisse was one of the Prime Dealers.

---

As always, there are some exception from the rules, especially to really senior customers. It was well documented medially (among many indicated by Reuters) that Chinese central bank (PBoC) was able to circumvent Prime Dealers and purchase large volumes of US debt directly at the source in the past. A magic trick that apparently even Bank of Japan (central bank of US closest Pacific ally) wasn’t able to achieve.

But Prime Dealers may of course be reluctant to purchase US debt on auctions, due to their own liquidity crunch, risk factors relating to US fiscal policy, overall economical expectations etc. And that is where counterparties have to negotiate for interest rates (yield) either satisfactory to all counterparties, or simply being effect of uneasy consensus. Had our kind readers just imagined representatives of main international banks and NY Fed bargaining on yield like on Arab marketplace (suk), we have to admit, we’re heading in the same direction.

And here comes one of the main principles regards to debt issued – that is what is opinion on its quality in the eyes of financial markets. If someone purchased security worthy 100 USD for 10 years and on fixed interests 3%, that means for 10 years, yearly will be receiving 3% of said 100 USD. Then issuer will re-purchase that IoU for 100 USD – settling the debt. For a longterm strategy it may in theory work. However banks tend to purchase them in attempt to held or grow value of assets and to be able to dispose them at any time, before maturity. In commercial banking, treasuries are equivalent of banknotes we circulate. So in the meantime what may happen is, that bond nominally worthy 100 USD, may be considered at such value only by us. And as there are adverse news about issuer having fiscal or liquidity troubles, and at the same time we need to be capitalised with money, it may be highly unlikely that someone will offer us face value of 100 USD. Instead we’ll be offered 85. Or 60. Or 40… And hence the problematic aspect. As according to appropriate accountancy rules, for the above example, banks report carrying amount of 100 USD in end of year / start of the year books, while in the meantime real market value of said assets diminished greatly. These are called unrealised losses - a difference between the carrying amount and fair value of debt securities at a given date.

In other words – you didn’t close your position, so you haven’t experienced loss.

On regulations, liquidity issues, means of banking and debt

International Monetary Fund states that types of assets held by central bank are generally limited by domestic statute. These statutes reflect the need for conservative central bank investment policies consistent with the goals of security, asset recognisability and liquidity. As a result, many central banks invest currency balances in deposit accounts at either central banks of different country or chosen currency, at the Bank for International Settlements, or, depending on credit evaluations, at large commercial banks. Other foreign currency assets may include sovereign debt, certificates of deposit ( from central or commercial banks), certain kinds of derivative instruments, repurchase agreements (either with the central bank or with private counterparties), and other liquid investments. A central bank may also hold banknotes of its own currency in offshore centres to provide for the international demand for the currency. So reserve assets – as per IMF’s – balance of payment manual may consist only limited options – internationally recognisable foreign currencies and debt, SDR, reserve position within IMF and gold. Apart of guidance from international banking institutions, there are also locally applicable guidances and rules, like it is in case of Basel III agreement, which we described in dedicated chapters in our analysis ‘Everything you'd like to know about gold in Poland, but are afraid to ask p. 2’ and ‘Gold in concept of common BRICS currency p. I’. We believe, there is no need to make copy / paste of appropriate paragraphs or rephrasing them. Instead we recommend above.

---

Central banks act as a local regulators on respective markets. They organise and participate in a settlement system, regulate locally commercial bank activities, support national and international banking settlement system, issue cash and credit money, influence amount of monies in circulation via interest rates, usual and nonstandard policies, determine value of money (i.e. by interventions on fx market). They also act as a country’s main accountant, maintain its bank accounts, deposits, international payments etc.

Of the above description we are able to determine, that central banks may experience losses occurring from adverse market conditions. It doesn’t affect however existence of central banking as their policy mandates include price stability and financial stability, not profit maximisation. Also, considering their function as a main banking body locally, they are not subject to capital adequacy requirements or bankruptcy procedures and can operate effectively even with negative balance. We mentioned that by the way, in our ‘Recession outlooks’ analysis. After all, when in need for capital (due to government’s fiscal policies), they have the most important privilege in banking sector – privilege to create money (out of thin air) in the way as described in previous chapter. Yes – it may dilute currency strength, fuel inflation and effect in lowering international creditability. But in the world of international banking, that is the right of the deity.

Above look is different in case of other banks – domestic, international, commercial etc. They can invest in wider variety of assets (i.e. that’s why they are present in Comex, LBMA and Shanghai precious metal exchanges), but these have to be legally regulated. Predominantly they operate on loans, deposits and treasuries. They are bound to local and international regulations and also have to keep obligatory banking reserves within central bank, with its size dependable on assets held and internal regulations.

---

Commercials invest and seek for profits. After all, they have shareholders and board expecting certain financial results. They set up a budget and try to achieve plan by providing and proposing wide spectrum of financial products to general population. These banks also have ability to create money, but they do so in relation to value loans they managed to successfully offer. And of course they charge interests and fees for certain products. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower's bank account, thereby creating new money. In short, money exists as bank deposits – IOUs of commercial banks – and is created through some simple accounting whenever a bank makes a loan.

Nowadays, there are more customers unable to leave debt spirale or struggling to pay loans. Demand for loans deteriorated, hence profits of commercial banks did as well. Credit became much more expensive, which affected not only bank-customer capital flows but also interbank loans like i.e. overnight repo. Of course there is also a wide spectrum of national interventionism policies, which support borrower’s creditability and hence lender’s liquidity. And another set of tools in hands of local central bank, that allows for liquidity injections in this way or another. But overall US policy is to shrink money in circulations, hence liquidity is being lowered.

One thing is liquidity and ability of creating money. Loss of value on assets held (i.e. bonds) is something else. And now funds, local governments, depositary institutions, pension funds but also foreign holders of treasuries experience unrealised losses on IoU held. That makes them vulnerable financially. Actually, that is applicable also to wide spectrum of all debt.

---

Above illustration is of course in relationship to US made government debt. But any entity meeting requirements may gather capital in form of debt issuance. So chart for USA extended in such way should look like this:

---

And for Euro-zone like this:

---

We strongly encourage to visit BIS site and do some comparisons by yourselves. Link is in description. And here comes another question – how many privately owned entities became zombie companies. Illiquid and barely afloat.

But it is the last chart which is most concerning. That is iShares TLT ETF for US 20+ years bonds. So basically passive investment instrument allowing for exposure on US long term debt. It experienced over 50% losses. Just this alone makes us wonder about actual market vs nominal value of securities issued around the world.

---

Year 2020 brought us extraordinary events and even more extraordinary countermeasures on nearly global scale. Year 2021 brought us issues on logistics and beginning of strong energy crisis in Europe. Somehow countered, but affecting Europe’s industrials ability to compete in the world due to elevated costs. Year 2022 brought us war on the European outskirts and deepening decoupling in the world. Like it wasn’t enough, year 2023 in addition provided another atrocities and acts of terror, in the region neighbouring to main oil reserves, which by the way in not very known for its stability. All of the above only proof that we witness extraordinary changes in the world.

With strong deterioration on market conditions, institutions suffer on lack of liquidity, caused among many (if not predominantly) by unrealised losses on treasury papers. Hence they tend to be more careful. Especially as standard approach seems not to be working in such extraordinary times. Most popular 60/40 portfolio balance brings losses, and markets are being pulled up either by handful of corporations. No one knows how long such artificially preserved pump mechanism may persist.

---

Hence major investment banks tend to keep price exposure to precious metals among many, even despite being affected by liquidity issues. Especially since there is a demand coming from customers for exposure tools.

However central banks are in possession of ‘deeper pockets’. And they seem to act currently as a very indicative indicator regards to how remain mid and long term liquid. They buy gold in a fastest pace in years, surprising even most experienced analysts.

But that’s a story for another time.