While the financial world chit-chats and wonders about equity markets, leveraged buy-out risk, mega-bank mergers, and blips up and down in the energy market, the most significant development in the world markets for this year is neglected: the slow rollover of the US bond chart.
The secular bull market that took off in August 1982 peaked about five years ago, of course, with the desperate efforts of the Greenspan Federal Reserve. But while US bonds have drifted sideways to down since then, long rates never really caught up with the economic recovery.
Now, though, if you listen carefully, you can see Mr Bond’s eyes clouding up, and hear the rattle in his throat.
That’s what I believe is driving the frenzied activity of some of the better informed private equity players right now. It’s not that economic and profit prospects are so much better now than they were a year, or even a few months, ago. It’s that at some level, conscious or instinctive, they know that cheap long-term debt is just about to be over. The chance to buy an option on future profits with cheap money is almost over.
There are two principal sources of demand that have kept Mr Bond suspended at these high levels: an asymptomatic rise in the leverage of bond dealers and emerging market central banks. The former is clearly more unstable than the latter; there is much attention to the trillion-dollar hoard of the People’s Bank of China and its affiliates, but much less attention on the trillion dollars of levered bond holdings that have been added by US primary dealers since 2001. The Chinese can stand to take a deep mark on the value of their Treasuries, since they didn’t borrow to buy them. Can the same be said of Wall Street? Can Wall Street add another trillion dollars in bonds bought on margin? If it can’t, how do the interest rates to private borrowers, perched as they are above the Treasury curve, stay low enough to keep the machine going?
And no, I don’t believe that China has any interest in dumping its Treasuries, or using them as some sort of negotiating leverage. That is the stuff of silly presidential campaign talking points, not serious analysis. But do the Chinese need to keep buying US bonds at the same rate they have?
I had an interesting conversation last week with Sheldon Kaye, a senior executive with Rosenthal & Rosenthal, a New York secured lender. R&R isn’t a bank but a privately owned asset-based lender to mid-sized businesses, such as garment manufacturers or art dealers. Not an industry that gets much attention, but one essential to the efficient functioning of the real economy. He had just returned from China, where he and Peter Rosenthal, one of the firm’s partners, were advising a group of Chinese officials and financiers on the mechanics of setting up asset-based lending operations. The symposium was organised by the International Finance Corporation, part of the World Bank Group.
“I’ve been talking to the Chinese for two years about asset-based lending,” Mr Kaye says. “In March they passed a law to set up a national central registry for registering movable assets such as receivables. They want to have it up and running by October. By next year, the banks will be able to start [taking] receivables as part of a financing package.”
This means that the small and medium enterprises that depended on either cash financing or borrowing from the Chinese Tony Sopranos at 30 per cent rates will be able to raise capital in a more transparent and efficient manner.
The Chinese banking system, which has been based on connections, bureaucratic or Communist party arm-twisting, or corruption, will take another step to transforming itself into a real financial system. And corporate finance will come a bit further out of the shadows.
So when Chinese accumulate cash, they won’t have to use as much of it to finance their enterprises. And they’ll have more local, yuan-based instruments in which to invest it. Which means they’ll have less need of the US Treasury market.
Innovations such as computerised national asset registries and incremental improvements in emerging markets’ local markets are needles approaching the surface of the developed world’s credit bubble.
No, it’s not an overnight change in the financial markets. Just as the bond bull market took decades to get to the point of financing this mega leveraged buy-out boom, so it will take decades to unwind.
In the meantime, by the way, I believe there’s a good chance that part of that Chinese asset hoard will go to buying up some of those US rust-belt corporations being bought up by the private equity tribe.
Why else would you want to buy an auto company? Who needs it, except, say, a Chinese manufacturer looking for an instant dealer network and assembly operation?
The gentle sideways movement of the bond market is within months of turning into the downslope of a theme park ride. It won’t happen all at once, but it will be relentless.