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Thoughts on the Bond Market Conundrum

Marc To Market's picture




 

This year's bond market rally remains among the most significant surprises of the year.  This is especially true for the US Treasury market, which, even if G-Zero hypothesis is valid, remains the critical global benchmark.  Fed tapering was widely expected to push up US yields.  Instead, they haven fallen.  The 10-year yield is off 60 bp this year,and nearly half of that decline has been recorded over the past month. Moreover, the US market rally has taken place amid a tick up in both core and headline measure of consumer prices.

There are many narratives being constructed as journalist; analysts and investors seek to explain this unexpected phenomenon.   While there are many interesting hypotheses, there is a dearth of evidence.  For example, talk of central bank purchases or lengthening maturities is possible, but the data is simply not available to verify or falsify such claims.  The latest TIC data is more March, and foreign officials were net sellers of both bills and bonds. 

Other hypothesis, like speculators, were caught wrong-footed, and the rally in the US Treasury market is a function of their short-covering, is simply contradicted by the facts.  Look at the recent Commitment of Traders report for speculative positioning in the futures market.  In the week that ended May 20, the gross short speculative position in the US 10-year Treasury futures contract rose by 26.1k contracts to 529.4k contracts (each one with a notional value of $100k).  As of late February, the gross short position stood at 346k contracts.  Their current holdings are the most since late 2004/early 2005.  Rather than reduce short positions, the bears have sold into the rally.

For their part, the bulls see more life in the rally.  They added 10.4k contracts to lift their gross long position to 436k contracts.  This is the most since last May.  Trend followers and momentum traders have been rewarded as yields have continued to fall. 

There may be something with duration extensions.  Due to the US Treasury auctions and the quarterly refunding, uncommon for the new supply of long-dated note and bonds to prompt industry indices (benchmarks) to lengthen duration.  Money managers who track such indices also lengthen duration.   Reading the entrails of recent auctions, some see evidence for this. 

There has been some talk of investors switching from European bonds to Treasuries recently.  It is difficult to verify it, but the decline of the euro is consistent with this.  Consider that the bigger rally in German bunds over Treasuries.  This had seen the US premium over Germany widen to 120 bp, which is the upper end that is has offered since 1990.  It has tested this level several times since mid-April and most recently on May 19. 

Bring in an international dimension is important.  There is a strong possibility of that the ECB will take unorthodox action next week.  In anticipation of this, some investors bought European bonds, which, in turn, may make US Treasuries more attractive.  In addition, the Bank of England has tried to convince investors that its rates can also be kept lower for longer.  Many in the market expect the BOJ ultimately to have to provide more stimulus if it is going to achieve the 2% inflation target. 

Another dimension is the regulatory environment.  Banks are being forced to raise capital ratios.  Many banks are increasing their sovereign bond holdings.  As the month of May draws to a close, the Federal Reserve is still buying more long terms securities than it was when QE3+ was first announced in September 2012.  This is taking place in the context of a sharp fall in the US budget deficit.  

This speaks to the relative shortage of Treasuries, but also of other core bonds, like German bunds.  Given portfolio optimiszation strategies and the desire to have core European bonds in global portfolios, there are not a sufficient amount of German bunds.  This forces some large pools of capital, including central banks, to by French bonds as reasonable facsimiles (with the understanding that France, despite it economic and political challenges, remains at the core).  

Back in the mid-noughts, Fed Chairman Greenspan identified a conundrum:  Why are US bond yields falling even though the Federal Reserve was raising short-term rates?  There  were various answers provided, but ultimately none proved very satisfying.  Bernanke, as a Fed governor, suggested, that it was due to surplus savings from Asia and the oil exporters, who did not have the capacity to absorb their own savings.  We now know that European investors were also large buyers of US long-term assets. 

The doom-and-gloom camp warned that QE was going to spark an inflation crisis.  It has not.  Many of the same people argued that the Fed was the only buyer of Treasuries.  No one else would buy them.  This too has proved wide of the mark.    Evidence for most explanations seems to be sorely lacking, and there are likely to be more than one cause.  Many have cited activity by central banks and sovereign wealth funds, which seem all too often be the go-to-explanation.  We would place emphasis on private sector participants and technical and regulatory issues in the context of the Fed and BOJ's ongoing significant purchases and anticipation of ECB action.

 

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Thu, 05/29/2014 - 20:19 | 4808022 MrFailSauce
MrFailSauce's picture

This post seems too reasonable for the inflation conspiracists...yet their criticism centers around grammar?

The author's conclusion seems very straightforward to me.  Bond and stock prices only necessarily move in opposite directions in a very simple two asset model.  If they're moving in the same direction we're seeing a flow from some third source.  International private purchases seems plausible.  Central bank manipulation was effectively ruled out when the predicted market collapse never materialized at the end of the previous rounds of QE.

Fri, 05/30/2014 - 01:09 | 4808677 Frilton Miedman
Frilton Miedman's picture

 

 

Agree.

Grammar and the possibility that he's a non-English speaking foreigner...all you have to do is read his bio to know otherwise.

Two mouse clicks and five seconds reading is too much an imposition.

 

Thu, 05/29/2014 - 18:01 | 4807578 I Write Code
I Write Code's picture

If others are hot for US bonds, can't QE be discontinued immediately?

Which is to ask, shouldn't ZIRP be terminated?  But that's a question that answers itself.

Thu, 05/29/2014 - 17:35 | 4807506 RMolineaux
RMolineaux's picture

This writer needs an editor.  His grammar is terrible and lots of times I can't understand what he is trying to say.

Thu, 05/29/2014 - 18:43 | 4807730 SAT 800
SAT 800's picture

Dont' feel bad, he can't either.

Thu, 05/29/2014 - 17:03 | 4807374 Da chief
Da chief's picture

Ridiculous.....what does anyone actually think Draghi can / will do??

He can't print ( it's illegal ) and there is no such thing as a "Euro Bond" so.....blah blah blah....

As well looking at COT ok great....let's look "backwards" to assess the future of markets?? COT is just another bullshit system of data owned by "you guessed it" - the boys trading against you.

 

I continue to marvel at analysis that actually "believes" all the bullshit numbers / headlines.

Draghi to do nothing. U.S Treasuries Yields to the moon.

 

 

Thu, 05/29/2014 - 17:03 | 4807373 Da chief
Da chief's picture

Ridiculous.....what does anyone actually think Draghi can / will do??

He can't print ( it's illegal ) and there is no such thing as a "Euro Bond" so.....blah blah blah....

As well looking at COT ok great....let's look "backwards" to assess the future of markets?? COT is just another bullshit system of data owned by "you guessed it" - the boys trading against you.

 

I continue to marvel at analysis that actually "believes" all the bullshit numbers / headlines.

Draghi to do nothing. U.S Treasuries Yields to the moon.

 

 

Thu, 05/29/2014 - 17:00 | 4807365 disabledvet
disabledvet's picture

How big is the holocaust museum again?

Thu, 05/29/2014 - 15:35 | 4806954 Frilton Miedman
Frilton Miedman's picture

Guys in the "hyperinflation" camp seem to have forgotten the FED rule change in 2008 (that was originally supposed to be implemented in 2011), paying interest on excess reserves.

This completely alters past comparisons to the behavior of excess reserves, whether it's good or bad down the road, I dunno.

The Fed can tweak that rate, removing or increasing the incentive to hold reserves.

I also suspect the CFMA has artificially affected prices, as with Rex Tillerson a few years ago testifying to Congress that oil prices are 30% to 40% inflated via futures speculation.

I don't see how this can't also be true for other commodities, softs & materials.

 

 

 

Thu, 05/29/2014 - 15:08 | 4806876 ebworthen
ebworthen's picture

"The doom-and-gloom camp warned that QE was going to spark an inflation crisis.  It has not."

You don't buy food do you?  Or health insurance.  Or pay rent.  Or buy gas.  Or pay utilities.  It would appear.

Treasuries will at least be liquid and not lose 50% when the next crash is engineered.

Lower rates, or a "rally" in Treasuries means the planned crash is nearing.

Thu, 05/29/2014 - 17:32 | 4807498 SAT 800
SAT 800's picture

Bonds, particularly Long Bonds, especially the Long US Bond, are seen as "safe havens"; the big rally means some serious people with a lot of heavy cash are "nervous in the service".

Thu, 05/29/2014 - 15:21 | 4806937 johnjkiii
johnjkiii's picture

Stagflation is stagflation after all. Wages are lower as well so we have a tax on consumtion that the cronies in this travesty will miss.

Thu, 05/29/2014 - 15:30 | 4806989 Frilton Miedman
Frilton Miedman's picture

True, and the Fed is walking a tightrope between wage growth instead of debt growth.

Back, full circle to Bernanke's 60 minutes interview a couple of years ago, stating we need structural fiscal changes, the Fed alone cannot fix this.

 

 

Thu, 05/29/2014 - 16:10 | 4807122 LawsofPhysics
LawsofPhysics's picture

"the Fed is walking a tightrope between wage growth instead of debt growth"  - LMFAO!!!

 

Right, show me a 30 year chart of the average wage and the total outstanding debt or the Fed's balance sheet.

Please, there is no "tightrope", they "created" credits out of thin air and made you do real fucking work while they also bought every single asset of real value, including your future.

and still no guillotines.

Thu, 05/29/2014 - 17:36 | 4807508 SAT 800
SAT 800's picture

you're right and he's wrong; he's amazingly naive.

Fri, 05/30/2014 - 00:07 | 4808601 Frilton Miedman
Frilton Miedman's picture

 

 

Now THIS is funny.

He misunderstood me, in turn, you parrot the misinterpretation.

Good boy!... ever thought of working in PR?

 

.

 

 

 

Thu, 05/29/2014 - 17:02 | 4807367 Frilton Miedman
Frilton Miedman's picture

 

 

That's exactly my point, households need income growth, not more debt.

Since 1980, the household debt to income ratio has gone from 65% to 105%, while wages are now at the 1988 level.

Ironically, the cost as a % of income to service that higher debt is at 1980 levels because of interest rates.

The hopeful note in all this, Yellen has specifically mentioned wage growth in public address regarding Fed policy.

Whether it's true or not the Fed is concerned, I dunno, not up for debating it either.

 

 

 

 

Thu, 05/29/2014 - 18:45 | 4807734 SAT 800
SAT 800's picture

A hopeful note !! LOL. What middle school did this come from?

Thu, 05/29/2014 - 13:52 | 4806403 wcvarones
wcvarones's picture

This guy needs a proofreader.

It's as if he doesn't even speak English and just vomited something into Google Translate.

Thu, 05/29/2014 - 18:47 | 4807744 SAT 800
SAT 800's picture

There's a lot of that going around these days; peoples edumacated in North America who imagine they speak English.

Fri, 05/30/2014 - 01:10 | 4808582 Frilton Miedman
Frilton Miedman's picture

 

 

Wow!!!

I'm going to trade your insight and make a freaking fortune!!

Not that it matters, but it might be a good idea to look at the author's bio (before making asinine assertions), his name is Marc Chandler - http://www.marctomarket.com/p/about.html

He's very American, English speaker too, an executive with Brown Brothers Harriman.

Now, Beavis, Butthead...you  two carry on, keep up the great work.

 

 

Thu, 05/29/2014 - 12:49 | 4806077 johnjkiii
johnjkiii's picture

That's why you should never listen to opinions. Our technical bond research has had us long all year and those who follow the biases of "pundits" are always be fooled by the markets. 

Do NOT follow this link or you will be banned from the site!