This Is What The Coming "Bond Shock" Will Look Like

With the Fed failing to stimulate "animal spirits" and reflate risk assets over the past 18 months, the one remaining trade in a world of central bank "Policy failure" was buying bonds, both government and now that the ECB is in the game, corporate too. Sure enough the world did just that: as we pointed out yesterday, with central banks having broken every market, the only possible "sure thing" is to frontrun even more future central bank action (and faillure) which as of this moment means just one thing: buying even more bonds.

This has led to a stunning outcome: as reported on Friday, from an absolute return perspective, US equity & global credit prices have been stronger than fundamentals imply. Paradoxically, as BofA's Michael Hartnett points out, this is due to the Mountain of Cash (i.e. bearish sentiment) & the fact that every interest rate in the world has been plunging toward zero. As a result, global government bonds are annualizing 23% YTD total returns, the highest in 30 years (see below). And currently, $9.7tn of global bonds are yielding <0%. This number will only grow as everyone rushes into the "safety" of bonds.

As BofA adds "despite unprecedented central bank policies of QE, ZIRP & NIRP, 655 rate cuts since the Lehman bankruptcy, $12.3tn of central bank financial asset purchases, prospect of a “one & done” Fed, central banks have lost the “War against Deflation”. They have failed to stimulate animal spirits depressed by the 4D’s of excess Debt, financial Deleveraging, aging Demographics and technological Disruption." This "central bank failure" helps explains the recent unprecedented scramble into bonds: a deflationary instrument... and trade.

But will it continue?

The only thing that can halt the tsunami of bond buying, would be a Bond Shock, an event that is certain to take place, the only question is when (the last time it took place was just over a year ago as described in "Two Years Later, The VaR Shock Is Back".

As Hartnett adds, the relentless buying of TSY paper changes "if Quantitative Failure spreads from Europe & Japan to the US."  Here's how to time it:

The precipitating factors would include a "rise in US bank CDS and/or a dive in assets related to consumer & housing credit would be very negative for global asset prices in our view. Note the new whispers of a peak in the US consumer credit cycle which, if true, at a time of zero rates in an $18 trillion, consumer-led economy would be concerning."

Alternatively, with interest rates dropping so sharply and bond yields in unprecedented territory, we believe vulnerability to a “bond shock” (a fast, unexpected rise in yields) is growing. A bond shock happened in Germany 2015, US 2013, Spain 2012, Japan 1998, 2003, 2005, and happens in EM quite often. Signs of credit market excess are evident today with HY Energy (H0EN) the most overbought in 6.5 years (14% >200dma) and US IG (C0A0) the most overbought in 3.5 years (4.6% >200dma).

And here is what the upcoming bond shock would look like, as well as how to trade it: "Table 1 explores the basic rules to follow if one expects a “bond shock”: stocks down, banks down a lot, consumer staples/healthcare outperforms, small outperforms large, FX reaction depends on capital flow needs… DM FX appreciates, EM FX collapses)."

In other words, while the Fed hates the constant buying of bonds as it reduces the funds available to purchase stocks, it will hate the sudden, dramatic repricing that would result from a bond liquidation also known as a bond shock, even more.

Finally, for those eager to quantify the damage, Goldman already did the math two weeks ago: a 100 basis point blow out in yields would result in losses of up to $2.4 trillion.

 And that's in the US alone. Add the rest of the world and one is looking at as much as $8 trillion trillion in global MTM credit losses.

We bring this up just in case there is still any confusion what the real reason behind Bullard's unprecedented recanting on Friday was, and why the Fed has now given up on renormalizing interest rates, precisely as we previewed two weeks ago in "Why the Fed is trapped."