The bond market is on fire and you are about to get burned!!! Bond yields are lower and interest spreads as tight or tighter than that of the bond market crisis of 2008. This will lead to a catastrophic financial train wreck that can happen at any moment. Why do I feel like I’m the only one sounding the alarms? Where is the media to help warn and prepare the marketplace? Why are investors going along and playing in what seems to be a rigged and tragically destructive game? It reminds me of the story of a frog jumping into a boiling pot of water. Once the frog hits the hot water, it jumps right out. But the frogs that is in the pot when the water starts out cold slowly gets cooked. The Fed has excessively accommodated financial markets for almost a decade. This has been such a long, accommodative cycle, investors can’t tell how close they are to getting cooked.
Some of the world’s largest and most sophisticated investors who pride themselves on being some of the smartest individuals are taking some of the most expensive risks with the worst payoff profiles of all time. Obviously, most investors have short term memories. Longer-term government bonds typically trade above the level of inflation by 2-3%. That should put the long bond around 5-6%. However, when there is an asymmetric skew in the economic data, like there is today, where growth and inflation has a higher probability to surprise to the upside, the premium should be even higher. Longer-term US Treasuries now yield 2-2.8%. If the longest US Treasuries normalize, the market losses could be as high as 50%!
Over the last couple of weeks, long dated US Treasuries rallied 40 basis points. That may not seem like much, but this is days before the Fed is going to raise rates another 25 bps. What makes this move absurd is that the rally happened not when rates are normal, but still priced for a recession or a depression. When factoring this 25 bp hike in short term rates, that is a 65 bp compression in spreads – a huge move! Why? Was there a natural disaster? Was there a financial catastrophe? Both of these might be justification for a 25 or 30 bp spread tightening. But 65 bps? 65 bps is over 20% of the US Treasury long bond yield!
What has come out over the last couple of weeks is that GDP is running around 3%, CPI and PPI – core and headline inflation are running 2%, the unemployment is at a cycle low of 4.3% and the Fed is hiking rates and going to reduce their balance sheet. This is an environment where overpriced bonds should be getting decimated because current yield levels are so low. It is clear that fundamentals have nothing to do with setting yields in the bond market. What has been setting yields is a consortium of Treasury market investors that have been high volume trading Treasuries aggressively during typically low volume periods and making the market believe – through price action – that there is great demand for bonds. This is nothing more than squeezing the bond market and giving it misinformation in hopes of bluffing bond investors to not pull the ripcord and cash out of the bond market.
This is not a unique strategy. This is the same strategy employed during 2006 and 2007 to coax longer term bonds into a low volatility state. This flattened the yield curve with declining long term yields as the Fed raised Fed Funds from the historically low 1% last cycle. And what did that lead to? This high volume, volatility diminishing trading of long term rates led to mispricing of all risks embedded in the bond markets. And when those risks eventually were realized (when Fed Funds raised high enough to be a substitute for overvalued bonds), the normalization process was rapid. This market move confused investors that were clueless as to what was setting yield levels before, during and after the crisis. The financial crisis of 2008 was only a crisis because yields were mispriced too low due to the manipulation in the Treasury market. If rates were normalized in 2008, there would have never been a crisis. Yields and spreads would have only moved a little bit higher instead of having to adjust so drastically that anyone with leverage or a low risk tolerance was forced to sell. This led to a lack of liquidity in the bond market and the Fed having to step in to provide liquidity. The Feds mistake is they provided the liquidity then and still are today. This encourages reckless risk taking in the bond market and the insanity continues today.
To make this last paragraph a little clearer, monetary policy in the last cycle was over accommodative. These conditions led to the 2008 financial crisis. The Fed’s response was to be even more accommodative for an even longer period of time. They expect different results this time? (Definition of insanity!) I fear with this next crisis congress will place the blame squarely on the Fed. The result, most likely, will be a different mandate for the Fed – if the Fed continues to exist at all. But I digress.
The Fed will raise interest rates in two days. The US Treasury Secretary Mnuchin just repeated he is looking into issuing ultra-long bonds (great timing). The job market is tight and global economy roaring. In the US, you can’t find a parking spot and homes are selling over asking price again. This is not the recessionary or depressionary conditions reflected in the bond market.
Congratulations to the Fed. They saved us from the last financial crisis by sowing the seeds of the next, never to be out done, even more spectacular financial crisis. The Fed has manipulated the markets by buying 5 Trillion of bonds and a consortium of bond investors are manipulating the markets, trading 1 trillion of government bonds in the cash and futures markets daily. If you think fundamentals are setting prices in the bond market, your wrong. Let’s be clear: when fundamentals matter in the market place, yields and yield spreads will be double to triple of what they are today. So get ready to hop out of the financial pot before the water gets too hot. With the Fed hiking rates and reducing their balance sheet and the bond market grossly overvalued, the pot may start to boil faster than most expect.
by Michael Carino, 6/13/17
Michael Carino is the CEO of Greenwich Endeavors, a financial service firm, and has been a fund manager and owner for more than 20 years. He has positions that benefit from a normalized bond market and higher yields. Do you?