Wednesday, June 17, 2015

Bond Bear Market Almost Three Years Old - Will It Get Worse?

The low in the ten year bond yield was almost three years ago, in July 2012. If I was starting this blog again today, I might call it Bond Vigilante!

There have been a series of higher lows in the ten year yield after the July 2012 low of 1.46%. First, April 2013 was 1.66% and now the yield is 2.3%.

Also, notice that - just this month - the downtrend in yields that was in place since the end of 2013 has broken.
Think of everything that depends on low 10 year yields: mortgage rates, car loans, the "Fed model" of equity index valuation, M&A deal pricing, capex decisions.

Having $3 trillion of assets under management puts you in the top handful of asset management firms. Owning $1 trillion of treasury debt (like China or Japan) makes you one of the largest holders. Who, then, is going to be buying the $3 trillion a year that federal, state, and municipal governments are planning to borrow to cover their operational and pension shortfalls?

Bonds are sitting on the precipice of a very, very nonlinear tipping point. Once bonds lose momentum, who will want to own them? Momentum (three decades' worth) is the only thing they have going for them, and professional asset management and retail investor sentiment are both all about momentum. Every credit - government or corporate - looks much worse with rising interest expense. I think we will come to realize that a lot of stuff in the economy (junk bonds, private equity) was part of a virtuous interest rate cycle.

For the counterargument that the Fed will just buy bonds to "keep rates low", you have to face the fact that QE invariably caused rates to rise, and you could (and we did) make money buying bonds every time the Fed stopped buying them. As I kept trying to explain, the QE bond purchases may have been respectably large in relation to the flow of debt issuance, but they were puny in relation to the stock of $60T of dollar denominated debt. It freaked creditors out about inflation more than it helped.

In Prechter's February 2015 Elliott Wave Theorist issue, he repeated his call that the July 2012 low in the 10-year bond yield (1.46%) was a major, multi-decade low. Although recently we have thought of bonds as the flight to safety asset (moving inversely with stocks), he correctly points out that bonds and stocks have been going in the same direction since the mid-1960s. Both have been in a huge bull market.

I had thought that bond yields cannot rise until after the stock market has crashed, because the government could just refuse to bail out the stock market and thereby "chase" people back into bonds. But I had not considered that people need to view bonds as perfectly safe in order for that to work. And treasuries clearly are not perfectly safe.

The legitimate purpose of public debt is to borrow money to build infrastructure improvements that have a positive net present value. However, a vast portion of federal expenditure now leaves nothing tangible, leaves no collateral. A treasury bond is a certificate that money has successfully been expended on section 8 housing, or on make-work military "jobs".

The lack of collateral makes these treasuries creatures of social mood. They are no more valuable than tulip bulbs or south sea shares. That makes them vulnerable to going down with stocks when social mood becomes more pessimistic. The only thing that would rise would be the dollar - which of course has had a massive breakout.

If you synthesize the best parts of Falkenstein and Redleaf, you predict that the next crisis is going to come in the investment that is currently perceived as riskless enough for highly leveraged institutions like banks to buy. Right now, government bonds are accorded zero risk in calculating bank capital ratios. The idea that government bonds are riskless when governments are planning to flood the market and when the expenditures are consumed (building no collateral) may prove to be the latest delusion.

Krugman has spent years poking at the "invisible" bond bear. The problem is that years of success at borrowing for consumption (not investment) without any noticeable effect on interest rates made the Keynesians in government complacent and cocky.


Anonymous said...

Really, though, a bond bear market would be something to celebrate. No more baby boomers hoarding empty houses. No more NSA data centers.

Taylor Conant said...

I'm glad to see you discussing this and would like to see you keep teasing the idea out. I congratulate you for revisiting your prior convictions and considering a different path. What do you think this means for gold? Have you considered how high rates might go when the bond bear arrives? Do you think its important to watch/comment on/predict global interest rates and bond prices for important trading nations? In this interconnected world where the CBs are essentially colluding on passing the inflationary hot potato it seems like you'd have to, and I'm curious on your current thoughts if so.

CP said...

In order to amortize the current public debt of $13 trillion over 30 years, the federal government would first have to permanently stop incurring budget deficits, and then the principal repayments would be about $433 billion a year.

Just balancing the budget is pretty unlikely, and to reduce spending by that much (taxing more will be self-defeating) and begin amortizing seems practically impossible.

Many people have observed this already, of course, but they were too early. Even Japanese government bonds are still increasing in value! I believe that the key insight is the astonishing demand for "safe" stores of value created by aging populations. Highly deflationary.

Realistically, this demand is going to grow, and they will borrow more at lower rates, digging the hole deeper.

We will watch for a chance to trade our "safe" treasuries for "risky" precious metals and oil, and lower rates and higher prices, respectively.

High Plateau Drifter said...

Matzah Ball Soup

Let me tell you that CP's charts of the rate on the 10 year treasury are compelling. Three years is a long time to wait for a new low in the rate on which virtually everything else is priced. But seriously, CP! Our Fed enabled deficit spending pissed away on Section 8 housing???

We should be so lucky!

It is being pissed away not only on Section 8 Housing vouchers as you suggest, but on EBT cards, on AFDC, on SSDI (for all those folks at Wall Mart who nimbly get up off their electric go carts to grab items from the top shelf when nobody is looking), TANF, and Medicaid – a bundle of goodies that costs .gov a fortune. There are more working age people on welfare than there are recipients of Old Age SS and Medicare benefits. The profits of exporting American jobs has been personalized while the costs in unemployment have been socialized.

As I have told CP many times, what we see now is exactly what you would expect to see in the very early “seedling phase” of a great inflation. Rising stock prices and a record run of stimulus from the central bank. Of course in the old days, whether it was Weimar Germany, Argentina, or Zimbabwe, one could sell one's locally priced stocks for cash as soon as the inflation rate passed the rate of increase in stock prices and immediately park it in a bank elsewhere in a stable currency to protect yourself. That dodge is no longer so easy now that the entire world seems to be inflating in unison with the possible exception of Russia. In addition to increased surveillance powers, limits on cash withdrawals and regulatory costs imposed on so called tax haven banks have caused them to close their windows to U.S. customers. Making yourself and your assets “illegible” to government is not as easy as it once was, and, I fear, now that that all governments are borrowing and inflating more or less in unison, the government to which you and your assets might flee is just as likely to steal from you as is our own Uncle Sam. For those of you who want to stack, I would suggest platinum rather than gold, since it is now cheaper than gold (for the first time in living memory), and because there is not enough of it in private hands to merit the costs of a confiscation effort.

So now we have clear signs of distribution in the U.S. stock markets, as the smart money begins the relatively disciplined process of exiting (high volume down days and light volume up days. The ghost of Jesse Livermore rides again!!) while luring in genXers and millennials at every minor dip, setting them up for the kind of learning experience that the 1973 highs of Dow 1000 handed to me back in 1974.

CP has the right approach for a narrowing market at all time highs, and that is to find companies with bonds that sell at or less than 60% of par and shorting the stock where he is virtually certain the stock will go to zero. The falling economic macro and gradual momentum loss of the markets will present him with lots of these opportunities, market crash or no crash, over the next couple of years.

High Plateau Drifter said...

Matzah Ball Soup (Continued)

But at my advancing age, I place great value on “atmospherics.”

Consider that every central banker knows perfectly well that the economies of the developed world, and especially the U.S., are in deep trouble and that there is nothing their beloved central banks can do about it. They have about as much ability to influence the economy now as the Kaganoviches, Davidoviches, Kamenevs, Rykovs, Kuibyshevs, Derzhinskys, etc. of politburo fame, had to plan and control the economy of the old Soviet Union.

The danger, of course, is the media and the investing public might realize this and, with rates stuck at the zero bound, understand that they as investors and the economy at large are “on their own” leaving the Federal Reserve powerless and irrelevant with only one option, resume printing money and hope that (a) Congress helicopter drops some of that money on middle class America (rather than just their campaign contributors) and (b) that the demographic forces of deflation prevent hyper-inflation. Wee Bennie Bernanke wasn't quite the right “atmospheric” for the job. He had that shifty look about him of one who knew more than he was telling. Of course Stanley Fisher, formerly head of the central bank of our 51st state on the Eastern Shore of the Mediterranean, who really runs the show as Vice Chairman, remains hidden from public view behind the curtain. So for public consumption the Fed nominates a somewhat frail and soft spoken Jewish Mother who will affectionately nurse the economy while it is sick and hopefully get it back to health with steady doses of Matzah Ball Soup that we get at her contentless press conferences. Now that's some serious “atmospherics” for you. By putting Yellen front and center, the Fed is admitting it has lost control. Now it is up to market participants, having lost their heads as a herd, to come to their senses one by one and realize that the Fed no longer “has their backs”.

Anonymous said...

Hardly anyone thinks rates are going lower , maybe this is the great contrarian trade. Sub 1/2 of 1 percent on the ten year before this is over I say . QE acts like an interest free loan to the government and the States credit card can go much higher as Japan has shown.

CP said...

It's true, the 10 year is cheap relative to most other government debt, e.g. German.