Monday, January 29, 2018

How Scary Is The Bond Market?

Brian Romanchuk of the Bond Economics blog posted a comment over the weekend, Bond Bear Market Scare Stories (added emphasis is mine):
Whenever there is an uptick in bond yields, scare stories about a coming secular bond bear market are not far behind. The problem with most of these stories is that they are not particularly compelling, and different people have been invoking variations of them for decades. Instead, if you want to come up with a much scarier bond bear market scenario, we need to drop some analytical assumptions, and think through the implications.

The Lame Scare Stories

Each commentator comes up with a different spin on why the Treasury market is about to collapse, and what the implications are. I cannot hope to cover them all. However, there are a few basic stories that quite often appear. Unfortunately, if we want to translate them to a (highly dated) pop cultural reference, they are about as scary as Dr. Tongue's Evil House of Pancakes.

Since I am only summarily dismissing these arguments, I will not waste the reader's time by trying to relate them to particular analyses.

The first (and most common) scare story is about rising inflation. (Admittedly, I always throw in a disclaimer about this scenario when discussing long-term prospects.) The problem is that we almost have three decades of stable inflation (since the early 1990s) in the developed countries. This period also included two oil price spikes, which did not translate into higher inflation. (In fact, they preceded recessions that led to lower inflation.) Meanwhile, commentators have been calling for an inflationary accident throughout that entire period. It is clear that we need some form of structural change to help sustain higher inflation.

The second scare story revolves around foreign central banks suddenly dumping Treasurys. These stories fall apart when we realise that even foreign central banks do not want to vapourise their capital. Furthermore, one needs to explain how the flows that lead to this liquidation will be sustained. Selling Treasurys implies a falling U.S. dollar -- making other countries exporters less competitive. Why exactly do these central banks want to sabotage their existing trade policy? Although it is possible to think of scenarios justifying such an outcome, there are a lot of moving parts in the stories that can break down.

The last set of stories are in the "who will buy the bonds?" category. Since monetary flows are circular, these stories never work.

The Scary Bond Bear Market Story

All we need to come up with a good bond bear market scare story is to examine common analytical assumptions. If we amend these assumptions, we have a story that is possibly as scary as the cinematic classic, The Bloodsucking Monkeys of West Mifflin, Pensylvania.

In the financial markets, it would be safe to say that it would be easy to find commentators that will endorse both of the following scenarios:
  1. If the central bank hikes interest rates, it will tend to depress growth, and hence inflation. (The exact transmission mechanism varies based on economic views.)
  2. If government debt gets "too large," bond yields rise, and then there is a fiscal meltdown scenario (leading to hyperinflation if the commentator in question likes invoking hyperinflation).
The interesting part of these two views is that they are contradictory: the first implies that rising bond yields suppresses inflation, whereas the second implies that they raise inflation. This is not a bug, it is a feature. Financial market commentators need to jump back and forth between bulls and bears rapidly, and need to have strong opinions regardless of what side of the market they are on. Embracing contradictory concepts means that they have a story to justify whatever their current view is.

In order to generate a more plausible secular bond bear market story, we need to dig into these contradictory views. One of the advantages of Modern Monetary Theory (MMT) is that the theory has dug into these assumptions, as opposed to conventional economics, where the first view (interest rates reduce inflation) is assumed to be true, and there is no questioning of that assumption.

All we need to do is to question the efficacy of rising interest rates to slow economic growth. (It should be noted that Warren Mosler has pushed the following logic the hardest; it may not represent the consensus of all MMT economists. What I am writing here is a paraphrase of Warren Mosler's statements over the years.)

If the policy rate rises, bond yields will also rise. This will imply a greater interest outlay by the government (on a lagged basis), as a considerable part of government debt is relatively short maturity. Furthermore, it raises the interest costs for the business sector, which is a net borrower. Conversely, the household sector is a net saver, and a lot of household borrowing is in the form of mortgages, which are largely fixed in the United States. (Other countries do not have 30-year fixed mortgages, so the interest cost adjusts more rapidly.)

If the household sector has a relatively stable propensity to consume out of interest income, the net result of rising interest rates is to increase household consumption. Rising consumption raises capacity utilisation, and that will likely be more important than the effect of interest rates on investment decisions. The bottom line is that rising interest rates may end up stimulating the economy, for reasons that are similar to the second story above.

However, the key is that this effect is relatively weak. The business cycle is not greatly affected by interest rates (absent the key possibility where a real estate bubble is crushed by higher interest rates).

If policy rates are not particularly potent tool, their precise level is an arbitrary decision of the central bank. This is completely unlike mainstream theory, where the economy spirals to hyper-inflation or hyper-deflation if interest rates are not automatically adjusted to achieve price stability.

In other words, the natural real rate of interest is a chimera. If the central bank thinks the real natural rate of interest is 2%, observed real rates should average 2% across the cycle. If it thinks the natural rate is 3%, the average will be higher -- with no observable difference in outcomes.

If we accept these premises, generating a self-reinforcing bond bear market is straightforward. A change in personnel at the central bank can result in a change to the central bank's reaction function; it could effectively target a higher natural rate of interest. Rising interest rates raise interest income, raising nominal demand. The resulting higher inflation will cause the more-hawkish central bank to keep hiking interest rates.

The only thing that stops this "doom loop" is the tendency of financial markets to blow themselves up. So long as the central bank does not get too aggressive, there is little reason for rate hikes to derail growth. Demand is rising, and although there are pockets of nuttiness in risk markets, private borrowing has been tepid so far this cycle.

In summary, all we need for a secular bond bear market is for Fed policymakers to stop panicking at the first whiff of a slowdown, and to resume rate hikes more rapidly after a recession. Once the pattern of cutting more in a downturn than during the expansion is broken, interest rates will be able to once again take an upward trend.

Is This Plausible?

Although this scare story is more plausible than others, there are still weak links.

Firstly, private sector balance sheets are heavily encumbered with debt. Unless wage growth is quite strong, debt service concerns will limit how far rates can rise. That said, a secular bond bear market would take place over at least a decade (by definition), and so there will be time to adjust.

Secondly, the tendency for the Bank of Japan to keep rates near zero acts an attractor for developed country interest rates. Hiking rates back to 5% again (for example) would create a huge carry differential, and risk pushing the yen to deeply undervalued status.

Concluding Remarks

I am certainly not calling for a secular bond bear market. That said, a change in the Fed's reaction function as a result of changing personnel poses an obvious risk to be monitored.
I enjoy reading Brian's comment because unlike others, it offers some much-needed balance and places these scary bond market stories in the right context.

For example, if you read this article on why it's time to exit Treasuries you'd think there's a run on the US dollar and Treasuries are cooked. This falls under what Brian calls Dr. Tongue's Evil House of Pancakes.

Every day US long bond yields rise, people get very nervous, following the action tick by tick:



Of course, the bond market matters. It's a lot bigger than the stock market and when rates start rising, investors get very nervous because a backup in yields, if significant, can clobber all risk assets.

Put another way, every asset class with risk is priced relative to the risk-free bond rate so when yields rise, it tends to make these assets less attractive relative to bonds.

Brian makes a good point that a change to the central bank's reaction function could effectively target a higher natural rate of interest but it's unclear that such a change will occur and more importantly, that any change in the reaction function targetting higher rates can be sustained.

Let's say the new Fed Chair, Jerome Powell, decides to raise rates by more than what the market is anticipating at a time when global PMIs are weakening. What will happen? The yield curve will invert and long-term deflationary headwinds will intensify.

There's simply too much debt, especially consumer debt, for the economy to withstand a pronounced and prolonged rise in rates.

What about Ray Dalio's story of "beautiful deleveraging"? I don't see it. US credit card debt just hit a record high as the average American has a credit card balance of $6,375, up nearly 3 percent from last year.

In fact, total credit card debt has reached its highest point ever, surpassing $1 trillion in 2017, according to a separate report by the Federal Reserve.

This is why I find a lot of holes in Dalio's assertion that a bear market in bonds is upon us. For someone who understands the bottom 60% is hurting, he makes these claims that just don't hold up.

My other issue is he doesn't understand his pension clients. If he did, he'd realize they're jumping on US long bonds to immunize their portfolios as long bond yields rise. Pensions have long-dated liabilities, as stocks soar and rates rise, they will rebalance and buy more long bonds to match their long-dated liabilities.

This was a point that Pimco's Ed Devlin made on BNN's Weekly with Andrew McCreath. You can watch Part 1 of this interview here and Part 2 here. I don't agree with everything Devlin states but he gets pensions. (You can also watch BNN Weekly here).

Anyway, you know my thoughts on the 2018 Treasury bear market, I think it's silly to forecast a sustained rise in US long bond yields. It just can't happen, the US and world economy aren't capable of withstanding such increases in US long bond yields.

This is why I keep telling you to use the recent backup in yields/ decline in prices to buy more US long bonds (TLT) here and hedge against downside risks of stocks:


Can the yield on the 10-year Treasury note hit 3% and prices fall further? Sure it can but the more people anticipate the magical 3% number, the less confident I am that we will see it.

Either way, the backup in long bond yields is starting to hit stocks and we are getting close to a point where equities can see a meaningful pullback if they keep rising:



Nonetheless, it's too early to tell whether the big pullback in stocks is upon us. The danger of irrational complacency still reigns supreme so don't get overly nervous if US long bond yields keep rising and stocks sell off after posting solid monthly gains.

The critical point I want to make is to take all these scary bond market stories with a shaker of salt. There is no bear market in bonds, none whatsoever, and any suggestion that there is and things will get worse simply isn't based in reality.

With global PMIs slowing and starting to decline, you will see a lot of bids for US Treasuries and the US dollar in the months ahead (yes, the two can rally concurently). The thing to watch for is whether the reversal will be slow and orderly or abrupt and harsh, like when markets crash.

I'm not worried about any crash but I am worried about irrational complacency and overly euphoric investors extrapolating recent gains in stocks well into the future.

I leave you with some final thoughts on bonds. An astute investor shared this tweet from Alex Gurevich, CIO of HonTe Investments with me:




This investor shared his thoughts with me:
Alex Gurevich recently posed the following question on Twitter: “Is it possible that corporate tax cut may prove disinflationary, as it will allow for more price competition and investment in productivity?”

It’s a fascinating question to me, because the disinflationary effect of zombie companies should be the same regardless of how they are kept alive, be it ultra-low interest rates, fiscal injections like TARP or slashing taxes?

If a competition to slash corporate tax rates spreads globally, as some have suggested it will, perhaps you’ll be adding corporate tax cuts to your list of deflationary forces.
Another sharp hedge fund manager shared this with me earlier today:


US 10yr Nominal Yield + 10yr Term Premium = 2.189% (as of JAN 25 close)

It will be time to own USTreasury duration shortly; upper channel within ~50bps.

Patience.
With the 10-year yield now trading at 2.72%, the 10-year term premium is negative, which leads this hedge fund manager to state the following:
2.189 projection is where I would look to position long, for a trade.

Yes, term premium is negative which is lunacy.

So, if term premium does not adjust north, 10yr ~3.20% is where we look to position.
So, he expects the 10-year yield to marginally overshoot 3% but as I stated above, it's not a given that we will see 3%+ in the 10-year yield.

Also, since everyone likes drawing historical charts of the US 10-year bond yield, a nice tweet from Cullen Roche:




Lastly, take the time to read a comment from Cam Hui of Pennock Idea Hub, The Pain Trade Signals From the Bond Market, where he explains why they feel the bond market is poised for a rally.

I particularly like the two charts below from Cam's comment (click on images):



Below, Wells Fargo's head of interest rate strategy, Michael Schumacher, warns a fire sale by the Treasury could send shock waves through the bond market. More scary bond market stories I would ignore.

Also, Erik Townsend welcomes Artemis Capital's Chris Cole to MacroVoices to discuss volatility and the alchemy of risk. The interview begins at roughly 12:30. Erik and Chris discuss:
  • Risks in share buybacks
  • Defining the short volatility trade
  • Explicit vs implicit short vol positions
  • Risk parity, VAR control, Risk Premia and CTAs
  • Considerations on the unwind of the short VIX trade
  • History of correlations on stocks and bonds
  • The scenario where we can have another 1987 market drop again
  • Consideration on the growing trend to passive investing
  • Potential catalysis for market triggers
The supporting slides to this discussion are found here and there is more background material here.

Cole states: "Leading up to the 1987 crash, 2% of the market comprised of portfolio insurance. Today, anywhere between 6% to 10% of the market comprises of these implicit and explicit short volatility strategies, and this should be concerning."

Listening to Mr. Cole, he's obviously a smart fellow talking up his book and likely doesn't see any value in hedging your portfolio using US long bonds. Unfortunately, he must be underperforming in this environment of irrational complacency eagerly waiting for something to crack.

Still, if you want to worry about something, worry about the proliferation of implicit and explicit short vol strategies over the last decade and how things can unravel very quickly if something goes wrong (Note: His thesis assumes central banks will not or cannot save the day, a very big assumption!).

And if things unravel fast, there's no doubt Chris Cole and other hedge funds designed to hedge against disaster will perform well but bonds will help save your portfolio from catastrophic losses (without hedge fund fees). Hedge accordingly and ignore scary bond market stories.



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