The Worst Case Scenario For Bond Bears According To JPM: Rising Stock Prices

We have previously discussed the massive, and getting bigger, Treasury supply/demand imbalance as we head into 2015, when none other than the ECB is expected to join the monetization fray alongside the BOJ, and as we previously reported using a Goldman analysis, while the BOJ is expected to monetize some 100% of all gross Japanese issuance, the ECB will buy some 90% of all Bunds Germany has to issue in 2015, as well as hundreds of billions in other European public debt.

So here comes JPM with its own even more startling analysis which finds that total central bank monetization of soverign debt will increase from $1.0 trillion in 2014 (between the Fed and the BOJ) to $1.3 trillion (between the BOJ and the ECB). Why? Recall Citi's analysis from October that "It Costs Central Banks $200 Billion Per Quarter To Avoid A Market Crash."

The fact that bond yields declined, credit spreads widened and the dollar rose over the past year demonstrates how atypical the current monetary policy cycle has been relative to previous cycles.


This atypical behaviour can be partly explained by the offset that the ECB and the BoJ provide to the Fed's tapering. Based on our revised call about sovereign QE by the ECB, we project that G4 central banks will purchase more bonds in 2015 than last year. We expect the ECB and the BoJ together to purchase $1.3tr of bonds this year relative to the $1.0tr that last year was bought by the Fed and the BoJ. And this is having a dramatic on global bond demand and supply. In our Nov 14th 2014 F&L report, we projected that the balance between supply and demand, i.e. excess supply, will widen from -$485bn in 2014 to -$412bn in 2015. But our revised call about sovereign QE by the ECB implies $200bn more of bond purchases and thus a balance between bond supply and demand that is closer to -$600bn for 2015, i.e. even more negative than last year. In other words, the demand/ supply backdrop is even more likely to remain supportive of bond markets this year. On our calculations, the balance between bond demand and supply has been supportive of bond markets during most of the post Lehman period years with the exception of 2010 and 2013. The wildcards of our bond demand/supply analysis are our estimates of bond fund demand by retail investors, the bond buying by commercial banks, the supply of spread product in Europe and the speed of asset allocation changes by GPIF.

None of this is news, and certainly not to anyone who read "Desperately Seeking $11.2 Trillion In Collateral", but for those still calling for soaring bond yields now that there is a "recovery", here is a hint: the frontrunning of central banks means there is $600 billion more demand than supply in 2015. It does not take rocket surgery to figure out what this unprecedented excess global Treasury demand means for bond, aka scarce "High Quality Collateral", prices.

Yet one thing which JPM did note to our surprise and which is sure to lead to yet another bloodbath for the momentum-chasing, levered beta entities formerly known as hedge funds, and who - in their complete lack of creativity - have once again put on the long S&P, short 10 Year pair trade on hoping that this is the year, is the following:

... US pension funds and insurance companies stepped up their bond buying during the mid two quarters of the year. The equity allocation [of US pension funds and insurance companies] had gone up and their bond allocation down by so much over the previous two years that they had to increase their bond purchases to stop their bond weightings from moving even lower. In a way, the more equity prices go up the higher the pressure on US pension funds and insurance companies to buy more bonds. For example, assuming equity prices rise by 10% this year, for their bond allocation to stay at 37% (same as of Q3 2014), US pension funds and insurance companies would have to buy $550bn of bonds in 2015.

And that's a half a trillion in additional purchases just out of static reasons, i.e., to keep allocations flat. If asset managers decide that "bond kings" like Gundlach are correct, and that bonds will generate better returns than stocks for the second year in a row, and decide to actively raise the bond allocation above 37%, then all demand bets are off.

However, even absent that scenario, the paradox emerges: another 10% increase in the S&P, something which is roughly in line with where the consensus sees the S&P500 saying goodbye to 2015 and the bond market is suddenly subject to a historic imbalance of as much as $1 trillion in excess demand, as a result of both portfolio allocation and central bank buying!

Said otherwise, the biggest threat to bond bears and everyone else who is short the long end, is precisely the very signal that said bears have misinterpreted as being the catalyst for the long-awaited bond market selloff: rising stock prices.

And then there is the flipside: if 2015 is the year when the inevitable 3rd consecutive bubble (after the 2001 dot com and the 2007 housing bubble) finally pops, which way will bonds trade then, or will this time be different and a wholesale stock market crash finally also result in a parallel dumping of bonds? If so, just what long-despised asset class will the algos end up having no choice but to buy then?