With all the talk of the US Federal Reserve performing another round of quantitative easing (which amounts to repurchasing medium and long-dated government debt securities in an attempt to lower long term interest rates and frustrate people into purchasing anything else where they can get a decent yield on cash), the markets have started to get a bit antsy on the macroeconomic front.

Since the strength of the US dollar is a huge global variable, whenever the US Federal Reserve does something, the rest of the world, including domestic US investors, will notice. And indeed, the world has reacted by tanking the currency. More interestingly, however, is the rise in treasury yields (lower treasury prices):

In theory when you have the full force of the US Federal Reserve behind a position (in this case, purchasing government bonds), you try to get out of the way. This time, the market’s reaction appears to be one of indigestion – an exit from bonds. This is very interesting and if the trend continues, will have huge ramifications on investor’s calculations as to what exactly constitutes a “risk free rate”.

It is increasingly clear that US government debt is not as “risk free” as people may think, and this risk should be appropriately adjusted in financial calculations.

The easiest way for an investor to directly take a stake in this (other than buying or shorting treasury futures, which is a relatively trivial transaction to perform) is to buy or sell units in NYSE: TLT, which is an ETF that contains long-dated treasury instruments of 20 years and above. TLT is down about 8% from two months ago, when US Treasury bonds were trading at a local minimum of 3.5%. During the pits of the economic crisis, the US Treasury bond traded as high as 2.5% as investors dove for the safest haven.

A question in the financial markets should now be – exactly how safe is the “safest haven”? If the answer is anything other than US government debt, this would explain the currency exodus.

As a comparison, Canadian long term benchmark yields have generally gravitated down from August – reaching a high of 3.72% in August, and currently trading at 3.45%, and a low of 3.33% seen in late September. Clearly, the crisis hitting the US bond market is not hitting the Canadian bond market, at present.

My perception is that if this is the beginning of a “run” on US long term debt, there will be huge financial ripples in the US marketplace – for example, what do you do when you see a corporate long-term bond trading at a yield of 7%, when the 30-year US government debt is trading at the same yield? We are not there yet, but rising US government bond yields will crush the corporate debt market window that is currently open.

Watch out, because I suspect things are getting exciting again.

I’ve been scanning the entire list of exchange-traded debt and asset-backed securities, and the number of securities that are trading at a substantial discount to par you can count with the fingers of one hand.

On the US side, you have subsidiaries of Ambac, AIG, and SLM Corp.

On the Canadian side, you have Clearwater Seafoods, First Uranium, Holloway Lodging REIT, Lanesbourough REIT, Newport Partners, Priszm, Royal Host and Sterling Shoes.

All of these companies have significant issues, so an investment in the debt of any of these issuers involve a substantial amount of risk, including their ability to refinance. Right now is the most debt-friendly time to finance, so one wonders what would happen in the event of a slowdown in the debt issuance market.

Via James Hymas, Fairfax Financial is issuing $250M in preferred shares, with a 5% yield, and 2.85% above 5-year government bond rates thereafter, and the (holder’s) option to convert to preferreds yielding a floating rate of 2.85% above 3-month government treasury bill rates every five years.

5-year government rates were 2.16% on September 24, and the 3-month note rates were at 0.90%.

Cheap, cheap financing. As issuers start to pound away on the fixed income side (due to heavy demand), it makes you wonder when the party will end. My strong impression is that companies should be extending maturities and securing their debt financing since rates right now are about as good as they will get due to such voracious demand for fixed income securities.

I don’t like calling tops and bottoms – it is nearly impossible to get the exact time correct, but it is possible to get close. The way you take advantage is by scaling in your orders and waiting for the executions.

Trends in the marketplace go on further than anybody usually expects. Fixed income securities (especially bonds) appear to be quite pricey at the moment. Also, I have been noticing a lot more sentiment on the retail side toward dividend-bearing equities, and doing a cursory scan on that side of the marketplace leads me to believe that performing screens on non-income bearing securities would bear more fruit at the moment.

Portfolio movement has been mainly selling securities and raising cash, due to lack of research time. In particular, there is quite a bit of US currency available for deployment, and it is has been nearly a year and a half since I have invested in US equities.

Yield is now down, but I am very liquid.

I notice that a certain local credit union is advertising a 5-year fixed mortgage rate at 3.45%, which is a very low rate considering it is about 125bps above government benchmark bond rates. Since the overnight rate is now 1%, they will not be making much margin on the transaction. This also implies they have confidence in the price stability of the local real estate market, and being in the Greater Vancouver area, makes you wonder whether this is a valid assumption.

Something that is not easily discovered is their loan criteria – for example, if getting such a rate required a 40% down payment, then the rate might be warranted since the bank would have recourse and recovery in the event of a mortgage default.

Looking at the variable rate market, the best rate I can find is 0.85% below prime (prime is currently 3.00%), but if other institutions are over-capitalized, this discount to prime will continue to increase as they compete for loans. It makes you wonder whether consumer demand for debt has slowed down.

If you put a gun to my head and forced me to choose a mortgage that would result in the lowest interest paid over a 5 year term, I would still go for the variable rate. However, that said, 5-year mortgage rates cannot go much lower than 3.45% – maybe down to 3%, but that’s about it before you really question the sanity of financial institutions offering loans at that rate.

There is some risk of short term rates rising even further in 2011 and 2012, but it doesn’t seem like such movement would be extreme if it did occur. For financial modeling purposes, the market is saying that the 2011 increase will be 0.43%. There are scenarios where this rate could skyrocket, and also scenarios where the short term rate goes back to 0.25% again (where sitting on a prime minus 0.85% mortgage is really inexpensive!).

When markets move in a direction, the trend typically goes longer than most people otherwise anticipate. The Vancouver Real Estate market is a great example, or I could just be completely wrong and not realize there is some fundamental underpinnings that I am unaware of.

I believe this lasting momentum is the case for the bond market – today, I continue to unload at a pace of a trickle some of my slightly-better-than-junk debt (long-dated maturities) because the quotations just keep going higher.

Fortunately, some of it is sheltered in a registered account so I can defer the tax hit for a future time, but some of it is in the non-registered account. There is a tax timing problem in that I ideally would want to carry forward gains into the 2011 tax year, but it is better to take the bird in hand, rather than waiting 4 months. The taxes have to be paid eventually, but I’d rather want to pay them in April 2012 than April 2011.

Chances are in four months the bond party will still be going strong (especially when people dump their annual RSP contributions into the hottest bond fund they can find), but as a bond investor, I am getting very concerned as to the macro movement toward fixed income products and accordingly am continuing to leak my positions to the market as quotations go higher.

My cash balance continues to rise in the portfolio. It is at a higher level (in absolute but not percent terms) than at the end of 2008!