With everyone and their mom confused at how bonds can rally when stocks (the ultimate arbiter of truthiness) are also positive, we have seen Deutsche confused (temporary technicals), Bloomberg confirm the shortage, and BofA blame the weather (for a lack of bond selling). Today, we have two more thoughtful and comprehensive perspectives from Gavekal's Louis-Vincent Gave (on why yields are so low) and Scotiabank's Guy Haselmann (on why they' stay that way).
Gavekal's Louis-Vincent Gave On Why Are Bond Yields So Low?
As long as men continue to age, they will probably complain that “things were better in their day” and that “the world is going to hell in a hand-basket”. Ignore for a moment that the proportion of undernourished people fell from 23% of the developing world in 1990-92 to under 15% in 2010-2012, that more than two billion people gained access to improved sources of drinking water in the past decade, and that never in history have so many people across the globe lived so comfortably—as far as financial markets are concerned, the ‘old-timers’ may have a point.
Indeed, anyone who started their financial career in the late 1990s has had to deal with the Asian Crisis, the Russian default and Long Term Capital Management failure, the Technology, Media, Telecom (TMT) bubble and collapse, the subprime bust and global financial crisis, the eurozone crisis and the past 12 months’ bond market taper tantrum and emerging market wobbles. In other words, there have been plenty of opportunities to catch the volatility on the wrong side. And these recurrent punches in the gut (combined with the recent violent rotation from growth stocks to value stocks or the fall in the renminbi), may explain why so many investors continue to seek the shelter of the long-dated treasuries, bunds and Japanese Government Bonds, despite these instruments apparent lack of value. Simply put, after almost two decades of repeated financial crisis, investors today do not have their forebears’ tolerance for pain. And so the old timers may be right: today’s young people are wimps, for both theoretical and practical reasons:
An inherent level of systemic risk? Most people intuitively feel Karl Popper’s observation that: “In an economic system, if the goal of the authorities is to reduce some particular risks, then the sum of all these suppressed risks will reappear one day through a massive increase in the systemic risk and this will happen because the future is unknowable”. In other words, suppress risk somewhere and it comes back with a vengeance to bite you on the derriere at some later date. Look at 2008 as an example: we cut up credit-issuing risk into tiny parcels and distributed it across the system through securitization, only to see the banks take on a lot more leverage and ultimately sink their balance sheets on instruments they failed to understand. Hyman Minsky summed up this inherent contradiction well when he stated that “stability breeds instability”. In other words, the more stable a thing is, the temptation rises to pile on leverage, which makes that “something” more unstable on the back end.
The notion of Anti-Fragile: the above brings us to the Nassim Taleb notion of “anti-fragile”: just as a parent who overly cocoons a child prepares that offspring poorly to function in the wider world, so policy-makers intent on cushioning the private sector from every shock in the economic cycle are a doing the overall system a massive disservice. By preventing the build-up of immunity, or the ability to thrive in crisis (i.e., anti-fragility), policymakers sow the seed for a greater crisis down the road (hence the repeated cycle of crises).
Lay the blame on zero interest-rate policy (ZIRP): following on the above, not only does ZIRP allow the survival of zombie companies (which drags down the returns for everyone) but it most certainly affects investors’ behavior. Firstly, by encouraging banks to play the yield curve and buy long bonds, rather than go out and lend. Secondly, because almost all investors hold part of their assets in equities and part in cash or fixed incomes. And in a world in which fixed income instruments yield close to nothing, the tolerance for pain in other asset classes probably diminishes all the more. Indeed, if an investor is guaranteed a 7% coupon on his fixed income portfolio, then a mild sell-off in equity markets can be easily dismissed. But drop the yield on the bond portfolio to 2.5% and all of a sudden, the slightest drop in equity markets risks pushing the overall returns of the total portfolio into the red... Unless, of course, one holds much more fixed income instruments than equities. Paradoxically, that growing population cohort which seeks a guaranteed level of annual income faces the perverse reality that low bond yields force an even greater allocation of their savings into bonds! And this quandary is further amplified by the last point.
The changing structure of savings: a generation ago, employees of large corporations would typically be enrolled in that company’s “defined benefits” pension plan. This meant that most salary-men, at least in the US, could look forward to a fixed monthly sum upon retirement, regardless of a) how long they lived for and b) what the market did. At that time, the overall behavior of financial markets was the concern of the pension fund’s managers who, if they were wise, could average up in bear markets and take some gains off the table when markets got hot; in other words, stomach the volatility of financial markets (backstopped by their companies’ long-term earning power) for the long-term benefit of their plan holders. But today, following the evolution of most pension plans away from “defined benefits” to “defined contribution”, the average pensioner’s relationship to his pension has been turned on its head. Today, the average saver receives a monthly statement explaining how much he has saved; and any dip in that amount triggers sentiments of panic and fears that a looming retirement may not be well provided for. Combine that fear with rises in healthcare and college costs (two costs that older folks have to worry about) that, over the past decade, have typically continued to outstrip inflation and any dip in the market is more likely to trigger a sentiment of panic, and rapid shift into bonds, then a willingness to ‘buy on the dip’ (see chart below).
Putting it all together, it seems hard to find one factor that explains the low level of yields. In our view, the ageing of our societies, ZIRP and the low level of rates, the shift from defined benefits to defined contributions, the activism of policy-makers (who, by attempting to cushion the volatility of the economic cycle more often than not end up increasing the volatility of financial markets down the road)... have all had a hand in keeping interest rates low. And if that is the case, then it will probably take a marked change in some of the above factor to trigger a significant rise in bond yields?
And Scotiabank's Guy Haselmann on why they'll stay that way... Long Treasuries March On
Low yield levels in global rates markets have perplexed many for much of the year. Most have expected US Treasury yields to rise as the economy rebounds from its winter hibernation. For the moment, the flattening of the curve and push to lower long end yields seems to be making Treasuries an ever-more unloved security class. Few envision any upside (in price). Yet, could there be information in the rally?
Positions matter. Most positions remain overweight equities, long credit and short duration, encouraged by 6 years of ZIRP and $4 trillion of QE. It feels like re-allocations are just beginning. A move back to benchmark weightings could have a material impact due to a lack of liquidity.
Are bonds currently telling us one thing and the level of equity indices another? Maybe they are telling us the same thing as the equity internals don’t look good.
In other words, UTY (Utilities) and XLP (consumer staples) - bond equivalents- are breaking out, while S5RETL (retail) and HGX (housing) seem to be rolling over.... Defensive stocks are outperforming.
Other causes for Treasury bid: QE reductions have reached the halfway point; the month of May begins the best seasonals of the year; the headwinds of China and Ukraine have ratcheted higher recently; and there is wide spreads to other sovereigns.
From now until October, markets have a good sense of what the Fed will do: end QE. And, Fed policy has been the key to market levels. I believe investor behavior has changed so markedly over the past several years that the investment environment over the next 6 months will be as simple as the following: QE encourages risk taking, so the end of QE will cause de-risking. It really is not, and has not, been about valuations (the price of money is too distorted).
While there have been some positional defensive rotations recently, the vast majority of portfolio exposures have yet to change. It is possible that they believe so completely in the Fed’s ability to engineer a return to normalcy that they will not re-calibrate positions from risk over-weights. However, it seems worrisome that bond market prices are suggesting great concerns on the horizons. Treasuries could be worried about deflationary forces and looking past the next few quarters (strong growth). They may fear, not just the impact of Fed policy normalization, but also a Chinese hard landing, and what they mean for 2015.
The Fed is in a quandary. If the economy begins to appear too strong, investors may begin to feel the Fed is ‘behind the curve’. There will be discussions about how the Fed has created another boom/bust cycle. (Jeremy Stein speaks tonight).
If the economy begins to weaken, then the Fed may lose credibility. With no bullets left, there will be discussions that Fed policy has become ineffective. Maybe the Fed requires a ‘Goldilock’s economy’ in order to not lose control of the market’s recalibration and reaction from its policy shift of ending QE.
I believe the FOMC would love to end QE immediately, but members have such great concerns regarding the market’s reaction toward the elimination of QE that they feel they must recede gradually.
Yesterday, the Fed had to pay above the market level in order to execute its buyback tranche (QE). Dealers may be having some difficulty finding Treasury securities that they are willing to sell to the Fed at market levels. In this regard, QE and the size of the Fed’s balance sheet may have reached their practical limits. The Fed has certainly been hoarding quite a bit of good collateral.
The story about corporate DB pensions drifting toward LDI continues to generate widespread market discussion. Even though this dynamic will play out over a very long period of time, it is causing some traders to question short positions in the long end. Many are trying to figure out the math behind the potential differentials between net demand and net supply compared to the existing float of available high quality long-dated fixed income securities. They are coming to the conclusion that demand exceeds the amount of secondary market securities outstanding. I remain a bond bull.
The curve is likely to flatten against the long end and long end yields are likely to remain under pressure. I maintain my targets for 5’s/30’s, 10’s/30’s and the 30 year yield at 100bps, 40bps, and sub 3.00%, respectively – by yearend.