Notwithstanding the Bank of England doing its best to inject £125 bln into the Gilts market, Gilt yields are backing up along with US Treasury yields and those of German Bunds.

There are basically two schools of thought as to why gilt yields are rising.  The more popular at the moment is that government bond investors are running scared of the deluge of supply of new government debt which is coming the market’s way over the next few years and the yield backup is a way of making room for all this new supply.  The other (less popular) explanation is that markets are anticipating economic recovery and the backup in bond yields simply represents the usual move away from risk-free assets to other more risky securities such as equities and corporate debt.

The second explanation is consistent with the rally in equity markets (with cyclicals such as retailers & mining stocks outperforming defensives such as pharmaceuticals, food processors & utilities) since early March and is also given credence by the synchronised backup in US, UK and German government bond yields.  The Dow has also broken above its 8587 May 8/20 double-top this week and is continuing the rally which started in March and which paused for breath during May (we have had two daily closes above 8587 which have negated the double-top reversal pattern).  The rally in the oil price is also consistent with an expectation of economic recovery and the only market not rallying is credit spreads.  Ordinarily these would be expected to tighten in anticipation of an economic recovery but this time it may simply be the case that banks are still not in a position to lend freely and the SIVs (which would normally be borrowing close to Libor and buying corporate bonds at wide credit spreads) are not in business any more.

Markets are clearly rallying in anticipation of economic recovery which means the rally will only be derailed by clear evidence that the economy is not recovering as per market expectations (i.e. we are still bumping along the bottom or we are going to double-dip back into a W-shaped recession); the catch is this evidence may not show up for quite a while…in the meantime it looks very much like the bears are going to be squeezed hard all summer long.

A new wholesale bank is born.  The UK Treasury has provided more details about its Asset Purchase Facility (APF), a £50 billion fund, financed by Treasury Bills & managed by the Bank of England, which will buy corporate debt, commercial paper, syndicated loans & asset-backed securities.  The stated objective of the APF is to “increase the availability of corporate credit” by making purchases which “would be most likely to restore the flow of finance to corporate borrowers”.  The plan is to wind down this fund as “normal conditions return”, i.e. when corporate credit spreads have tightened back into historical ranges, mostly by allowing existing assets to mature (rather than pressuring the market with a £50 bln overhang of paper).

The BoE has been directed to publish a quarterly account of the APF’s transactions together with an assessment of developments in corporate debt markets.  These accounts are sure to be eagerly awaited by the market – given that the BoE has been directed to buy “high quality assets”, any company which gains the BoE seal of approval will surely see its credit spreads tighten.  But then again that is the purpose of the APF, to tighten spreads and improve liquidity in the corporate debt market.

Whilst the prime objective is not to make money, the APF most certainly will – pots of it.  With 5-year investment grade corporate debt currently yielding in excess of 6% and Treasury Bills yielding less than 1%, this is going to be a good business for the UK taxpayer to get into (and I can’t see any of the APF’s profits being paid out to BoE employees in bonuses either).  But if this is such a great idea – why didn’t anyone think of it before..?  Well, Citigroup did when they invented the Structured Investment Vehicle (SIV) in 1988.  Like all banks, SIVs borrowed short & lent long (in their case buying bonds financed by issuing commercial paper).

Citigroup’s idea lasted 20 years until August 2007 when worries about losses on SIV’s assets caused commercial paper investors to refuse to lend the SIVs any more money.  Game over.  Whilst all the existing SIVs were closed down or went bankrupt post-August 2007 (Sigma Finance, the last surviving SIV went into liquidation in October 2008), the APF mirrors the idea perfectly.  The APF won’t suffer funding problems because Treasury Bills will always find buyers and any losses the APF suffers will be covered by the Government.  A 5% spread on £50 bln implies profits of £2.5 bln annually (credit losses will be non-existent as any company enjoying access to APF funding is highly unlikely to go bankrupt), the APF will prove to be a source of revenue which the Chancellor is going to be reluctant to shut down.  The SIV is dead, long live the SIV.