Thursday, February 22, 2018

The Bond Teddy Bear Market?

David Ader wrote a comment for Bloomberg, Too Much is Being Made of the Bearish Bond Data (click on images to enlarge):
“The sky is falling; the sky is falling!” Substitute “bond prices” for “sky” and you’ll have a sense of the mood in the fixed-income market the last few months.

I won’t diminish the potential bearish impact the swelling U.S. budget deficit will have on the bond market as supply surges in the months and years to come. But we don’t know how much it will affect the market if there is no accompanying increase in inflation and gross domestic product. Still, that hasn’t stopped people from making too much of bearish data, while ignoring a soft underbelly that challenges the bearish narratives. That’s what I’m about to do.

Certainly, five increases in the federal funds rate since December 2015 and the doubling in 10-year Treasury note yields since mid-2016 would constitute a bear market by any measure, but what I suspect is coming is more of a teddy-bear market than a grizzly bear, at least based on recent statistics and hyperbolic stories throughout the press.

First, I’ve read, reread and read yet again articles about the deficit exploding. We knew of that danger well before the tax plan was enacted into law in December. Each report pretty much rehashes the same statistics in an attempt to explain the rise in volatility and interest rates. In reality, few dollars have been added to the deficit projections. When old news is rehashed as new information it can arouse emotions without adding more to the fundamental picture.

Second, there’s the selective use of data events, which I have also used to my advantage. Take the consumer price index. A greater-than-expected increase on Wednesday provoked a sharp selloff in the bond market and was followed by press reports of inflation coming back and, along with a weak retail sales report that same day, led to the term “stagflation” being thrown around.

But here’s the thing: January is a notoriously bad month for inflation. On average, it shows the second-highest monthly increase over the course of a given year and is the highest for the core figure, which excludes food and energy. This particular January had very cold conditions, which may help explain that two of the largest contributors to the gain in the CPI were energy and apparel. In other words, from an historical perspective we can expect month-over-month gains to ease.

Another weather quirk can be seen in the January employment report. While the 200,000 increase in jobs was not too threatening, the surge in wages caught the attention of the bears and is cited along with the CPI report as a reason to dump bonds. It’s not so simple. A lot of people were not at work due to bad weather, and maybe because of the flu, which explains the dip in hours worked. The 0.3 percent gain in average hourly earnings was skewed to a small segment of the workforce, the upper echelon. Production and non-supervisory folks, who account for 80 percent of the workforce, saw a more modest increase of 0.1 percent. These are the people who couldn’t get to work due to bad weather and whose hours worked dipped to 34.3 from 34.5 in December.

It’s also important to understand that the CPI data took a toll on inflation-adjusted earnings. Real average weekly earnings fell 0.8 percent in January, and real average hourly earnings dropped 0.2 percent. That might help explain the weak retail sales data that were largely ignored by the bond market.

Then there’s an empirical measure of sentiment in various forms, price action not being the least of them. One of the best contrarian indicators -- and one that has worked for me for almost 30 years -- is the Daily Sentiment Index. This is a survey of small traders in actively traded futures put out by Network Press. Essentially, the survey asks if you are bullish on a given commodity. When the index falls below 20 percent it means that more than 80 percent of the “market” is bearish. And when the market in question becomes that oversold, it typically marks an inflection point and foreshadows an impending reversal. The DSI for 10-year note futures slid under 12 percent a few days ago and remains a very oversold 14 percent, begging the question of who is left to be bearish.

So is Chicken Little right to run around yelling the sky is falling? At the end of 2017 I wrote that I expected 10-year yields to rise to around 2.85 percent to 2.95 percent, which they’ve done rather earlier than I expected. The evidence suggests yields at those levels provide value, at least in the near term. However, there’s a chance yields could probe the 3 percent to 3.25 percent range at some point toward the middle of the year as the sheer weight of increased issuance spooks both the Fed, due to the added stimulus of the tax plan, and the marketplace that has to buy many more bonds. Yields teasing into that range should be enough to boost the dollar and prove ample competition with a richly valued equity market.
This is an interesting article and I thank Drew Wells, one of my astute and faithful blog readers out in Vancouver for sending it to me.

I've been highly skeptical of bond bear market stories for a while and have relayed my thoughts in my macro comments thus far this year:
Now, I spend a lot of time going over bonds because the bond market is much bigger and far more important than the stock market. In order to understand risks and liquidity, you need to understand the bond market.

It so happens that today I met up for lunch with Simon Lamy, a former senior fixed income portfolio manager at the Caisse. Simon traded bonds for close to 25 years at the Caisse and not only was he one of the best fixed income traders ever at this organization, he was also one of the nicest guys there and I had the pleasure of working with him and my former BCA colleague, Brian Romanchuk, back in 2011 when we worked with external consultants to understand sovereign debt risks and opportunities.

Anyway, it's one thing writing about bonds but Simon is trading them actively for his one-man hedge fund, posting great returns and not answering to any boss (he's in an enviable position).

So, for me, it was a treat meeting up with him. I started off working on fixed income at BCA Research, I understand the macro environment, but it's totally different speaking to a bond trader who traded sizable positions and knows the Canadian and US bond market very well.

We first started talking about the Caisse's 2017 results which I covered yesterday. Simon wasn't particularly impressed, said the overall results came in line with the benchmark, and that apart from Private Equity, it wasn't a great year. Moreover, he said Canadian Equities underperformed in a year where the TSX/ S&P underperformed so he didn't see any value added there.

I actually updated my last comment to state the following:
A quick glance shows me that apart from Emerging Markets stocks, Private Equity really performed well in 2017, returning 13% versus a benchmark return of 10.5%. I also noted solid performance in Real Assets (Real Estate and Infrastructure) and decent performance all around except for Canadian Equities (Canadian mandate) which underperformed the index by 100 basis points in 2017 (but outperformed it by 150 basis points over the last five years).
And I reminded Simon that it's the 5-year (long-term) results that ultimately count most. He agreed but rightly noted, "it's been a bull market since 2009 and for all this talk of resilient portfolios, the Caisse hasn't been tested out yet apart from the minor correction that took a few weeks ago."

There I agreed with him and said: "100% correct. The real test for Michael Sabia and the senior managers at the Caisse and their resilient portfolios will come when we get a nasty bear market, this last correction was just an appetizer."

Anyway, enough about the Caisse, let's get back to my discussion with Simon on bonds. I jotted down some mental notes on things he told me:
  • Like me, Simon doesn't buy the whole big bad bond bear market story. Instead, he sees US bond yields going back to their historic norms trading between 2% and 4%, going back to the historic range of US nominal GDP growth. So he sees 3% as a long-term neutral level for the 10-Year Treasury yield, not the upper range of long bond yields when looked at over many years.
  • Importantly, he doesn't see sustained US wage inflation and I agree and have written my thoughts here.
  • He told me he would short US long bonds if the yield on the 10-year Treasury note fell below 2% and go long if it crossed 3.5% and approached 4%.
  • He thinks the market is going to test the psychologically important 3% level on the 10-year Treasury yield. "The market is almost there and barring a terrible US jobs report next Friday, we're likely going to test it." I was surprised when he said that because it has been my contention that we might test or briefly overshoot 3% but I had serious doubts because the US economy is going to slow markedly in the second half of the year.
  • Simon told me to watch supply and demand. "There are supply concerns now because typically when you see the economy expanding and the Fed tightening, you'd see a decrease in the supply of Treasuries but now because of the tax cuts and expanding deficit, you're seeing an increase. That puts upward pressure on yields. If the economy was slowing, no problem to absorb the increase in the supply of Treasuries because demand will be there."
  • As far as demand for Treasuries: "Forget the bid-to-cover ratio, that's not a good indicator of demand. Watch how the market reacts moments after supply hits the street. If yields rise (bond prices fall) moments after, then you know demand isn't strong even if the bid-to-cover ratio is high."
  • He didn't make any big call on the US economy, just focused on long-term trends. Told me that US GDP growth is made up of productivity growth which has averaged between 1.5% to 2% and population growth "so it's hard seeing GDP growth above 4% or below 2% for a sustainable period."
  • We spoke briefly about Canadian long bonds but he's not going long just yet and thinks the "Bank of Canada should have raised rates and instead is sitting on its hands using NAFTA as an excuse not to move." He added: "I just short the Bank of Canada's moves which is why I made great returns buying preferred bank shares when the Bank of Canada unexpectedly dropped rates a few years ago using the decline in the price of oil as an excuse to do so."
I'm not doing justice to Simon and our conversation was more intricate than the points above but he got me thinking maybe I've been too bullish on US long bonds (TLT) too early (click on image):

Still, given my firm views that the US economy will slow in the second half of the year, I'd be a buyer of US long bonds at these levels, especially if the yield on the 10-year Treasury note crosses 3% (I’m not convinced it will).

In fact, Drew Wells sent me the latest Markit US PMI report which was very strong and I thought to myself it's as good as it gets for the US economy.

I asked Francois Trahan his thoughts on the strength of this report and he shared this with me: "Brexit. Takes 18 months for a change in yields to show up in LEIs. The decline in yields around Brexit dropped yields below what would otherwise be for about six months. So some of this is artificial but real nonetheless."

Hope you enjoyed this comment on the bond teddy bear market. Please remember to kindly donate to this blog on the top right-hand side, under my picture. I thank all of you who take the time to donate and thank Simon Lamy for a great lunch, I really enjoyed our conversation earlier today.

Below,  Hayden Briscoe, UBS Asset Management, discusses why yields to on some US auctions rose to highest levels since 2008.

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