Via Scotiabank's Guy Haselmann,
Violets aren’t Blue
Long dated Treasuries will rally from here; particularly into the spring as we exit the March refunding. The shortage of high-quality positive-yielding bonds will only be exacerbated further by the ECB’s QE program which begins on March 1st. Presently, there are $4 trillion of bonds globally that have negative yields. German bonds, the largest beneficiary of the ECB’s program, have negative yields out to the 7-year sector. A Fed rate hike (June) will accelerate the pace and magnitude of the drop in back end yields (flatter curve); the accompanying ramifications that come with a stronger dollar will provide additional support.
In several prior notes, I have outlined reasons why demand for Treasuries have and will continue to out strip supply. The technical shortage of Treasury securities, combined with their relative attractiveness, will continue to trump any assessments of ‘value’.
In addition, Treasuries are one of the last remaining safe-havens. I believe this last point is important because as the Fed initiates its pivot toward rate hikes, it is hard for me to imagine that financial markets will be able to circumvent a new financial crisis, regardless of how ‘gradual’ the FOMC’s path to normalization. I expect Treasuries to receive ‘crisis’ (risk-off) inflows that will take yields back toward all-time lows.
Financial repression and belief in the “Fed put” pushed investors further and further out the risk curve over the past six years. Too many asset managers have remained fearful of underperforming peers and benchmarks; a powerful incentive to stay ‘risked-up’. The psychology of bullish, and faith in Fed abilities, have been too firmly embedded in the investor class.
Today, the Fed’s balance sheet is no longer growing and lift-off is looming, so investors need to stop believing that the Fed will lift asset prices in perpetuity. Their fear of missing the upside is an imprudent (and potentially irresponsible) reason to stay exposed to the riskiest assets that do not fully or adequately compensate an investor for the assumed level of risk.
Financial markets are upside down. They are distorted by extreme experimental central bank policies and by disruptive competitive currency devaluations. As the owner of the world’s reserve currency, ending the dangerous ‘race to the bottom’ policy actions have to begin with the Fed hiking rates.
There are N # of currencies and N-1 number of exchange rates. As the world’s reserve currency, the USD is the Nth currency, so it has an extra degree of freedom. It is for this reason that the Fed can have a dual mandate. Other major central banks cannot be the first to hike rates or they risk being left too far behind.
Yellen’s testimony was a success. After a long period of using rigmarole ‘Fedspeak’ to explain questionable policy maneuvers that were primarily designed to ‘buy time’, Yellen spoke more clearly this week. Despite considerable caution, she accomplished her goal of giving the FOMC more flexibility without disrupting ‘risked-up’ financial markets.
Odds are very high that ‘patience’ will be removed at the March 18th FOMC meeting. She has watered-down the impact when it is removed, but since there has not been a hike in rates since 2006, many investors remain skeptical of seeing any hike in 2015. There is another set of investors who plan to remain aggressively positioned until they actually see a rate hike (greater fool theory). After the March FOMC meeting and purge of the word ‘patient’, Fed decisions will be on a meeting by meeting basis. It seems many of these investors might be ill-prepared or slow to adjust.
Markets don’t seem to want to believe it, but a June hike looks probable. Given that I expect an outsized market reaction to a hike, I do not find it inconsistent to also expect lower long yields to accompany it. I also expect a flatter curve, wider credit spreads, higher market volatility and materially lower equity markets. If I am wrong about a June hike, it would likely be due to a problematic geo-political event or material economic underperformance in the US, both of which would benefit long Treasuries.
Given the Fed’s policy pivot, it is possible that asset manager outperformance will now come from under-weighting their benchmarks and the riskiest assets; after all, asset prices over the past several years have been driven more by Fed policy than strong fundamentals. If the Fed is going to hike in June, then first movers (out of the riskiest assets) may have a material advantage for outperformance. This is particularly true if my beliefs are correct that:
1) the upside/downside return distribution is highly skewed to the downside;
2) moral hazard (speculation) has been exhausted will the Fed’s flat-lined balance sheet;
3) crowded trades are widespread, and;
4) market illiquidity is pervasive.
"...What’s puzzling you, is the nature of my game..." – Rolling Stones