After almost 10 years of unprecedented accommodative monetary policy both in the US and abroad, the fixed-income markets are trading at lofty levels never before seen in history. Let that sink in for a moment. Never before. Not during world wars, not during global depressions, never.
If you think this is a case of scare mongering or me doing my best Chicken Little imitation, it’s not. One third of global fixed-income bonds were recently trading at a negative yields! The global bond market has never been in a more perilous position, and I am surprised that there are so few publications ringing the alarm bells. We are reminded on a daily basis of such trivial risks that have no bearing on our everyday. But it’s tough to understand why there is such limited press highlighting such glaring risks. This is especially alarming since we lived through a fixed-income debacle in 2008 and know how devastating it was for those unprepared.
The world is fully invested and on the same side of this one-trick global bond market trade. The hysterical purchases that drove bond yields so low by governments, sovereign wealth funds, banks, insurance companies and hedge funds seem to have abated and sales have just begun. Who becomes the marginal buyer of global bonds at these inflated prices? The world has become accustomed to bond selloffs getting backstopped by global central banks. This parachute of low funding and outright government bond purchases that investors had relied upon as protection from losses is largely behind us.
The Fed has begun a rate rise cycle which will include allowing purchased bonds to roll off and not be replaced as they mature. It appears other central banks are planning on winding down their quantitative easing programs as well. Banks have largely finished hundreds of billions in regulatory mandated bond purchases. Sovereign wealth funds and pension funds are selling bonds to dip into needed cash for spending. Governments that have amassed trillions in bond portfolios as a result of managed currency programs are shrinking these portfolios as well. And hedge funds that have recently grown assets into the hundreds of billions, investing in these overvalued bonds, trying to convert 1% yields into 7% plus returns with the use of leverage, are starting to see redemptions. One could always hope for a negative shock such as a recession to bring out the marginal buyers at these prices. But there are no signs of a recession on the horizon nor would that be a guarantee of buyers entering the market at these levels.
Limited global bond buyers outnumbered by new issue bond sellers should lead to higher bond yields going forward. If there was a trigger that encouraged the over 100 trillion bond market to start selling, prices could adjust lower rapidly. And there are many triggers on the horizon. With housing prices increasing over 5% annually, health care prices expected to rise steeply, global food costs rising at the fastest pace in years and wage pressures just beginning to percolate, inflation is poised to surprise to the upside. Fiscal spending (or at least promises of such from our Presidential candidates) is expected to increase, leading to higher growth rates and reducing the allure of bonds. And recently announced redemptions from large hedge funds who are typically leveraged and long the bond market will lead to pressure on bond prices. We will see if these hedge funds’ outperformance was the result of those magical algorithms or just good old-fashioned leverage in a market that was trending straight up. Most importantly, removal of accommodation from monetary policy will deflate assets that are greatly inflated.
But how overvalued could bonds possibly be? It’s been years since bonds have had any losses and most traders and portfolio managers have never experienced a bear market in bonds. When any market moves in only one direction for almost a decade to such lofty levels, there is not much preparation for a market reversal. Anyone positioned for a market reversal over the past 10 years has long since been blown out of their trades, fired or worse. There is a reason why betting on normalized yields in the bond market has been called the “widow maker” trade. Today’s perception that bonds are a safe investment is a mirage. The bond market has roughly doubled in size in the last 10 years and any selling could be catastrophic. Bond yields are much lower and prices higher than during the onset of the 2008 bond market debacle. This is a benchmark for overvalued bond prices and what to expect from a resulting market correction. If that’s not enough to get you to take pause, let’s look at a real life example. Longer dated bond yields historically average around 2% to 3% above inflation. Given today’s level of inflation, longer dated bonds should yield closer to 5% instead of the current 2%. If long bonds normalize up to that 5% yield level any time soon, the resulting price drop would equate to market losses of 40% or more!
Now you know bond prices are in the outer stratosphere. You’ve been warned of the risks if you have been counting on a monetary policy parachute to give you a safe landing. The central banks have started to take the parachutes out of the planes. Beware if you plan on skydiving.
Michael Carino is the CEO of Greenwich Endeavors, a financial service firm, and has been a fixed-income fund manager and owner for more than 20 years.