What a true bond bear market looks like
A couple of years ago I remember having a discussion with a hedge fund manager. I told him about my theory that the next big surprise would be higher bond rates, not the other way round. I distinctly remember him lecturing me about the overwhelming forces of demographics, technology and globalization. All of these added up to deflation – not inflation. I couldn’t convince him that when everyone agrees on something, it’s time to expect something different. We agreed to disagree.
Today, the tables have completely turned. It’s now fashionable to be a bond bear. So much so, I probably don’t need to repeat the common bond negative narrative that has spread through the financial community faster than chlamydia at a Banff youth hostel.
To see the preponderance of negative bond sentiment, all one has to do is look at the speculative positioning in the fixed income futures market. One of the easiest ways to hedge against higher interest rates is the CME 3-month Eurodollar contract. This contract has nothing to do with the euro currency, but instead represents the rate at which banks lend US dollars to one another overseas. Speculators are so confident about higher rates that they are short almost $4 trillion ED futures.
That’s a mind bogglingly large position.
And it’s not confined to eurodollar futures. The US 5-year treasury future is also stuffed full of speculative short positions.
The anecdotal evidence is also adding up. Market legends are appearing all over the newswire – warning about fixed income.
“With rates so low, you can’t trust asset prices today. And if you can’t tell by now, I would steer very clear of bonds,” Paul Tudor Jones at a recent Goldman event.
It’s easy to see why these pros are so bearish. The tape looks like crap.
You might notice that I have been focusing on the front end of the yield curve. That’s on purpose.
Not all parts of the curve are the same
During the next part of this post, it might appear I am making contradictory arguments, but it’s important to note that different parts of the yield curve react in different ways. It’s not as easy as just saying you are bearish on bonds and then shorting TLT. It’s much more nuanced, and without understanding all the dynamics in play, you might find yourself right about your call, but not making any money.
Anyway, here it goes – the statement most likely no one will like. The short end of the yield curve is oversold, while the long end has not even started to understand what a true bond bear market looks like.
Huh? What do I mean by that? Well, I think the front end of the curve is overly optimistic about the Fed’s ability to keep hiking, while the long end of the curve is way too sanguine about the Fed’s skill in controlling inflation.
So far, most market participants have assumed that Central Banks will keep inflation under wraps. As economic indicators have continued to tick higher, markets have pushed yields up at the front end of the curve. This has traditionally been the playbook. Economy does better. Market rates rise. Fed follows curve higher by raising Fed funds rate. This continues until rates rise enough that the Fed inverts the yield curve and the economy rolls over. Then the Fed slashes rates and the whole process repeats.
What’s different this time is that the stakes are so much higher. Although the Fed has raised rates as the economy improved, the consequences of going too fast scare the bejesus out of them. The Great Financial Crisis is still very much gnawing at the back of their mind. Much of Europe is still experimenting with negative rates, Japan’s massive QE and pegging of the 10-year rate ensures their shadow level of interest is still firmly below zero, and to top it off, until recently, inflation has been relatively muted throughout the globe. So it’s no wonder the Fed has not rushed to get out ahead of the curve and raise rates aggressively. Up until a few months ago, overly easy financial conditions were about the only reason to raise rates.
But now that inflation is perking up, many market participants are aggressively selling the front end of the curve, assuming the Fed will raise rates to combat rising prices.
I think they are wrong.
Don’t misunderstand me, the Fed will raise rates – just not as fast as the market expects. And let’s face it, forecasting the direction does not matter. Forecasting the actual amount versus expectations is what pays the bills.
Why do I feel the Fed will be slow to raise rates? Two reasons; the Federal Reserve’s and Treasury’s balance sheet.
Let’s start with the Federal Reserve.
Four-and-a-half trillion dollars of securities. And although they vary in maturity, a fair slug of it is long dated.
More than half of it is longer than five years in duration. Holding a portfolio of this monstrous size was all good and fine with rates at 25 basis points, but don’t forget, as the Federal Reserve increases the IOER (Interest on Excess Reserves), they increase the cost of funds that they are paying out.
(Bloomberg) – The Federal Reserve system provided for payments of $80.2 billion to the U.S. Treasury in 2017, down from $91.5 billion in 2016, based on preliminary results released Wednesday.
* Fed’s estimated net income was $80.7 billion in 2017, down $11.7 billion, primarily due to an increase of $13.8 billion in interest expenses
* Interest expense rose to $25.9 billion, mostly for interest paid on reserve balances deposited by commercial banks at the Fed; interest expenses on repurchase agreements was $3.4 billion
* Interest income on securities held by the Fed totaled $113.6 billion; foreign currency gains were $1.9 billion
* Operating expenses were $4.1 billion for reserve banks, $740 million for the Board of Governors, $724 million for costs related to producing, issuing and retiring currency, and $573 million for the Consumer Financial Protection Bureau
* Other services provided $442 million in additional earnings
* NOTE: The Fed raised interest rates three times in 2017 in quarter percentage-point steps, increasing interest rates paid on reserves, and began trimming the size of its balance sheet, thereby reducing interest income from securities it holds
There is a large contingent of inflation/deficit hawks who believe the Federal Reserve should immediately crank rates to head off the coming inflation. Paul Tudor Jones’ rant sums up their feelings awfully well:
Allison Nathan (Goldman): So, what should Powell do?
Paul Tudor Jones: Unlike his predecessors, he needs to be symmetrically fearless. Policy unorthodoxy needs to be reversed as quickly as it was deployed. After Alan Greenspan ignored the NASDAQ bubble, it crashed and led to this incredible foray into negative real rates. That created the mortgage bubble, which was initially ignored by Ben Bernanke and ultimately spawned the financial crisis, leading us to fiscal and monetary measures that were unfathomable 20 years ago.
Today, we need a Fed chair who is proactive, not reactive. Policy-wise, that means moving as quickly as possible to raise rates and restore appropriate risk premia so as to promote the long-term, efficient allocation of capital. While this will hurt a bit in the short run, it is better than the intergenerational theft that is being perpetrated now with the combination of low rates and high deficits. And it definitely will promote a more stable long-term economic equilibrium.
Let’s take a moment to think about Jones’ solution. Let’s say that instead of raising every other meeting, the Fed changes to every meeting (just like Greenspan did during the 2004-6 cycle). That would mean 8 raises a year, which would translate into $69 billion in extra interest expense for the Federal Reserve. By early next year, the Federal Reserve would be breaking even on their $4.4 trillion portfolio and from then on, every increase would cost the US Treasury an extra $8.6 billion. Now, I realize this is all semantics. Whether the Fed or the Treasury pays the bill, it doesn’t matter from an absolute point of view.
But can you imagine the uproar if the Federal Reserve was not only raising borrowing rates on the average American (who are struggling with high debt loads), but also demanding the Treasury send them an extra $100 billion a year to maintain these high rates?
And how do you think Trump & Co. will feel about this increase in rates?
The Federal debt level is more than 100% of GDP. The US simply can’t afford higher rates.
Especially since the Treasury has consistently missed their chance to extend duration to protect against raising rates.
Although wise sages like Paul know that it is better to take the hit up front rather than simply letting them fester until they explode into a crisis, the history of humankind does not make this a good bet. Nope, the higher probability outcome is that the problems will be pushed off into the future until the markets force the issue.
I am sure many of my regular readers will be sick of hearing this, but I will repeat it anyway. As Bill Fleckenstein says, “Central Banks will continue with their easy money policies until the bond market takes away the keys.”
The specs are short the wrong part of the curve
The speculators are short the front end of the curve assuming that inflation will be met with higher rates. To some extent they are correct, but the Fed (and all Central Banks for that matter) will be extremely slow to raise rates. Any excuse at all will cause a delay. An economic hiccup? Pause. Worries about a geopolitical event? Pause.
And you would think that this might be bullish for bonds, but no, far from it. A Central Bank that is not willing to invert the curve and take the economic hit from forcing a recession is a bond investor’s nightmare. After all, apart from default, inflation is the absolute worse thing out there.
Here is where my argument gets really confusing. I am bearish long bonds because the Fed will be overly easy. And even though it feels like bonds have entered into a vicious bear market, you ain’t see nothing yet.
I can’t remember where I heard the line the other day, but supposedly AQR’s Cliff Asness believes when evaluating market strategies, you should take the largest historical drawdown… and double it! He argues that markets have a way of surprising us with moves that we have never before experienced.
I couldn’t agree more.
We have had a 35 year bond bull market. Almost no one in the investment industry can remember a period where bonds went down for a considerable period.
Have a look at this chart of the total return of the US 10-year treasury future.
Yeah maybe we are down 10 handles from the high, but in the grand scheme of things, this is barely a scratch. It’s like the Monty Python’s Black Knight. Although the bond market has lost an arm, ‘tis but a scratch.
Before this is all through, the bond market will go through years of negative returns. The latest dip is just the start and by no means represents the worst of the bear market.
The term premium on long dated bonds will explode higher, and the yield curve will eventually hit record wides.
Bonds are going down, but mostly because no one will be able to afford higher rates, so therefore no government will raise rates high enough, thus creating the inflation that bonds fear the most.
Buying the front part of the curve and shorting the long end is probably the best risk reward trade on the board. I told you it wouldn’t be as easy as simply shorting the TLT…