Bond Yields - "You Ain't Seen Nothin' Yet"


If You Only Look At One Chart…

Time is short, so here is one chart to get you thinking in a new direction.

Velocity of Money (M2)

M x V = P x T

Source: Bloomberg

The chart that no central banker wants you to see

Velocity and inflation will continue to fall as long as debt compounds faster than GDP growth.

The secular low in bond yields is still ahead of us.

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Right Here, Right Now

The best trading ideas of the week from RVP Contributors

Buy some Insurance

Says Stray Reflections

In the past two decades the VIX has closed below 10 on only 11 occasions, and 7 of those occasions were during the past month. Sound normal?

“Low volatility begets high volatility. Some participants shared painful experiences that taught them consistently betting on higher volatility is a fool’s errand. Better to buy puts as insurance when option pricing gets too cheap. With the S&P 500’s realized volatility down to just 7% (it has been lower only 3% of the time since 1928), now seems like a good time.”

Jawad Mian’s report suggests that now may be the time to buy some put options to take advantage of a potential spike in volatility. With the time value of options so low due to suppressed volatility, now might be the time to take out a little insurance. Remember, you can’t get it cheap when you need it most.

Even deeply out-of-the-money, long-dated options could experience an asymmetrical payout in the event of a major unexpected risk event….

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The Big Call

Legendary hedge fund manager Stanley Druckenmiller said when you see something in the market that really, really excites you, “Bet the ranch on it.”

These are the Big Calls, the investment themes that can make or break you.

Think differently from the crowd and have a different time horizon, and you have an edge. RVP, with its crack team of financial minds, identifies the Big Calls and guides you through the investment opportunities when they present themselves.

Bond Yields

In Limbo or Playing Limbo?

We often refer to the state of being ‘in limbo’ as stuck on the edge of hell with no resolution… But remember, limbo is also a dance from Trinidad in which people compete to dance lower and lower under a bar until someone eventually collapses. This week in The Big Call we ask, how low can global bond yields go; and what could raise the bar, or will bond yields be stuck at current levels forever?

Bond bull alive and kicking?

The secular trend of declining bond yields has seen prices rise inexorably during a 30-year bull market. Our call from April 7th was to go long TLT on a short-term view – which has returned a decent 3.5% to date. But how long can this return continue in the face of rising leverage and deteriorating demographics? That’s something we considered in the Are You On This Yet? section of The Hack on May 19th

Drowning in debt

Jawad Mian’s thought-provoking symposium this week, A Dozen Ideas to Get You Thinking Differently, sets up our discussion nicely:

“The US economic return on additional debt has fallen to about 20 cents on the dollar. That means 80 cents is servicing existing debt, which has been borrowed for the purpose of supporting unproductive consumption and jobs. This makes economic growth very sensitive to changes in interest rates.”

The diminishing return of each new unit of debt is making it harder and harder for governments and corporations alike to juice their growth and returns. With debt levels so high, the service costs become punishing. To avoid a default, interest rates must remain structurally lower for longer just to support the present debt. Furthermore, the debt has to grow just to service the exisitng debt. Think about that for a second?

Are higher rates already the death knell for the US economy?

“It would only take a 20% backup in interest rates before the debt service becomes problematic (depending on duration and the amount of outstanding debt). The 10-year Treasury yield nearly doubled from the summer 2016 low, which suggests the US economy is about to slow down, rather sooner than later.”

The economy is slowing, and yet with these debt levels across the world, the growth rate required to get out from under them is essentially mathematically impossible to achieve:

The path of least resistance for central banks becomes structurally lower interest rates, since a widespread debt jubilee is too politically unpopular, for now. That comes later.

Central banks are stuck between a rock and a hard place.

  • how to prevent those low rates blowing up (even bigger) asset bubbles
  • how to keep banks profitable so they can recapitalise organically
  • how to have any levers of monetary policy left during the next major downturn

Across the world central banks are in a bind, and so developed bond markets are sleepwalking toward a Japanese-style scenario of negative bond yields and a deflationary psychology.

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Global bonds – The world tour


At the government level Chinese debt-to-GDP looks very reasonable at around 43%; but if we add in all the local debt, state-owned enterprises, and other forms of debt we get estimates of more like 250% of GDP, which makes China look rather Japanese. China does, however, have one advantage, which is a high GDP growth rate that can be used to shrink that debt load – but with so much growth generated from debt-fuelled investment rather than consumption, it will be hard structurally to grow the economy whilst weaning it off the debt.

Chinese government bond yields have been on the rise, which may actually reflect positive fundamentals in the economy. As Jim Walker’s Wealthy Nations observed in March,

“The rise in rates is a reflection of success and economic acceleration, not a reflection of economic problems. China will increase interest rates not because the authorities are worried about over-indebtedness and/or the amount of credit being extended.”

Cyclically, then, China seems OK for now – the PBOC has been stepping in with liquidity when needed as they try to steer the economy towards some corrective actions. However, the jury is out on how long they can keep this up.

For more in-depth consideration of Chinese debt dynamics, remember to check out CrossBorder Capital’s “The Financial Silk Road”.


The 10-year Treasury currently yields around 2.2%, a very low return by historical standards, especially when debt-to-GDP has ballooned to over 100%. Both metrics are now at their post-war level. Will foreigners question the US’s creditworthiness and abandon their debt?

As long as the USD remains the global reserve currency, demand for dollar debt will be high; and only the US bond market has the depth for this size of capital flows – i.e. many holders of Treasuries buy them for reasons other than risk/reward.

OK – but the world could abandon the dollar… Sure, but what’s the next largest alternative? The euro…


The Grecian debt crisis is now entering its seventh year of tedium. In that time debt-to-GDP has mushroomed from 126% to 179% – a debt level no nation has ever emerged from without some form of default or devaluation. Yet Greek bond yields have fallen from >30% in 2012 to just under 6% today.

With a succession of bailouts, Greece has trundled along on life support. As the old Soviet joke goes, ‘So long as they pretend to pay us, we will pretend to work’.

But what do people who want euro-denominated collateral do, then?


The 10-year yields are on the floor – 0.25%! This is due to a flight to quality in the Eurozone: If the EU breaks up, you are best off with bunds because the Germans have greater fiscal rectitude (although debt/GDP is still near 70%), and a new Deutsche Mark would be worth a lot more than a freshly minted drachma.

So what are we learning here? Bond yields – especially government ones – are not really reflecting economic risk/reward anymore. They reflect a belief that central banks will ease into perpetuity – or at the very least a belief in the ‘greater fool theory’.

This isn’t theoretical economics confined to classroom textbooks; we only have to look to Japan to see this train wreck in action.


Japan has a debt-to-GDP ratio of 250%! Yet the 10-year bond yields just a handful of basis points. What could possibly explain this? Deflation. Decades of deflation have meant that owners of any fixed monetary asset will see its value increase over time. Japan was stuck in a debt-deflation cycle until the recent advent of ‘Abenomics’ – the competitive devaluation and money-printing game that everybody else had been playing.

Either way, Japan has avoided default through extremely low interest rates, extremely high domestic bond holdings, and a highly cohesive society, all in combination with a weak currency and an export-led economy. Is this the future for other developed sovereign bonds?

The BoJ have only a plan A: Buy up all the bonds in issue. And after that? You can be sure that Japan will be at the vanguard of the next economic and monetary experiment. Remember that debt jubilee I mentioned?

Japan Debt to GDP vs Japanese Bond Yields

Source: Bloomberg

Could we see a bond scare?

The reality appears to be, it’s unlikely. Yes, an individual country like Greece can suffer a huge bond scare, but for larger nations with printing presses such as the US and Japan, the most likely outcome is simply more debt and more devaluation. And with plenty of money sloshing around chasing too few assets, bonds will probably continue to be bid.

The only thing that would reliably kill the bond market is higher interest rates from central banks. The trouble is, higher rates would also kill the market for everything else and trigger a depression.

Could an inflation scare occur? Demographics, unproductive debt, and technological advancements put the chance of a sustained period of inflation pretty low, despite (or because of) the best efforts of Central Bankers.


Baby Boomers are compounding the problem.

As we noted in The Hack on April 7th, ‘Baby Boomers Coming of Age’, the backdrop of an ageing demographic and massive pension black holes will structurally cap any rise in interest rates.

‘According to the Federal Reserve, unfunded state and local pension obligations have risen to $1.9 trillion from $292 billion since 2007. Throw in the private sector and that figure is far greater. At the same time pension funds have been pushed up the risk curve as interest rates from fixed income are simply inadequate. Baby Boomers have never been more exposed to equities and are going to start to drawdown their capital for retirement.’

The paradox is this: To fill that black hole and provide fixed income for retirement, we need bond yields above, say, 5%; but with yields above 5% the ability to service the debt mountain collapses and assets are liquidated. Wealth is devastated. Then, all those retirees will be shifting assets from equities into fixed income in the next decade, driving a huge wall of money into a bond market with diminishing yields.


What about cyclical considerations?

We have been stating for some time that the credit cycle is rolling over. Just last week Michael Lewitt noted:

“I no longer expect interest rates to rise significantly from current levels in the current cycle; they are more likely to fall as the economy stays weak and debt continues to build in both the public and private sectors. We could see short-term 25 or 50 basis point spikes in longer rates (10–30 years) based on an errant comment by a central banker or some piece of news, but rates are likely to stay down until the current business cycle, which is very long-in-the-tooth, ends.”

With the Fed raising rates into a slowdown, they will have to backpedal in the near future to soften the economic blow.

How low can we go?

The limbo continues – and the bar goes lower. For now, it is hard to see any alternative to more debt and lower rates. The inflection point where we could grow our way out of this debt straight jacket has passed.

The secular low in interest rates appears to still be ahead of us.

Are You On This Yet?

In such a fast paced world staying on top of relevant market news and developments is tough. RVP scours the globe for the most interesting stories and distils them, keeping you ahead of the crowd.



Brexit may be hanging in your mind as one of those tail risks you are supposed to worry about but cannot quantify. In The Hack for May 26th we looked at the importance of UK/EU trade and politics amidst what appears to be a messy divorce with a potential EUR 100bn price tag.

The EU debt crisis remains the elephant in the room, with poor demographics, massive welfare commitments, huge debt loads, and a one-size-fits-all currency to bind the mix – the potential for a full-blown crisis remains as real as ever. Is the UK just the first rat to leave the ship?


Is it all doom and gloom for Britain?

This week Eurizon SLJ Capital published an excellent report outlining the potential opportunity for the UK to become a tax haven upon exiting the EU. What if Britain just refuses to pay the ransom note, endures a hard exit, and then steals all the EU’s corporate business? What if the breakaway from the EU allows Britain free rein to shape its own industrial policy?

Stephen Jen of Eurizon SLJ Capital argues that once free from EU encumbrances, the UK could move forward with corporate tax cuts to fuel greater inward foreign direct investment (FDI). The UK is already the greatest recipient of FDI in Europe. The UK has a strong base of FDI due to credible institutions, strong rule of law, the English language, high-quality human capital, and good infrastructure. The opportunity for greater future FDI could be huge if the FDI stock matches that of other tax havens as a % of GDP:

Check out Switzerland, Ireland and Luxembourg.

Source: OECD , IMF, Datastream and Eurizon SLJ Capital

UK in the Sweet Spot

If the UK sparks a boom in FDI, taking business away from the Eurozone by having a more competitive corporate tax rate, that shift would have effects akin to the competitive devaluation of currencies we have seen since the GFC.

But tax havens act differently: They have to be small enough to attract business away from larger economies but still large enough to retain the social and economic depth required to support large businesses. Britain appears to sit in the sweet spot:

“In the middle – what we call ‘Middleweight’ economies – we may have a sweet spot for corporate tax cuts. The loss in revenues from the reduction in the tax rate may be easily offset by the new inflows of foreign investments. If the costs for a company of operating in London were driven lower, we believe this would tilt the balance on FDI flows away from, say, Dublin. The point here is that larger and more sophisticated economies command a premium on smaller economies that can.”

This analysis gives a read across for the Trump tax cuts for investors. As the US is a ‘heavyweight’ and really operates its tax system under its own gravity due the sheer weight of its GDP and global importance. In the case of the US, cutting corporate tax may actually hurt the fiscal situation rather than having the impact of attracting enough FDI to compensate for the tax cut.

Surely cutting taxes blows up the fiscal balance sheet?

It may be that reducing the corporation tax rate further to a ‘sweet spot’ actually attracts more investment from abroad and results in more job creation in the UK, putting money into the pockets of residents and giving the government a greater tax base from personal income. Corporate tax is after all a form of double taxation – both the corporation and its shareholders are taxed on profits and then dividends.

There’s got to be more to Britain’s chance of success than just tax cuts?

To have a winning formula you also need industrial policy:

“It would make sense, in a medium-sized economy like that of the UK, for there to be (i) more guidance and leadership from the government and (ii) concentration of financial and intellectual resources in the development of industries… In a globalised economy that offers ‘winner-takes-all’ propositions, or non-linear financial rewards, there is a role for the government to lead and nurture the industrial development process, in our view.” 

Currently the UK ranks no. 7 in the World Bank’s Doing Business report, above Germany, Ireland, and Austria. Denmark is the only member of the EU to rank higher. If Britain can continue to attract FDI and see it invested wisely in profitable and scalable sectors, there could be a winning formula on hand for greater growth outside the EU.

Even if you have Brexit exhaustion, you need to read Eurizon SLJ Capital’s analysis – it is incisive and comprehensive and deserves to be a white paper floating onto the desks of leaders across Europe to drive forward some more functional politics.

Does Theresa May have the balls?

Britain has its destiny in its own hands. It needs a bold government to make some bold decisions, but otherwise, all the ingredients are there for success.


So Much Volatility, So Hard To Find

Picking up pennies in front of steamrollers…

Volatility is an oft-used measure to gauge risk in financial markets. This week we explore a few facets of volatility; and we ask why, with so much uncertainty in the world, is volatility so low?

Jawad Mian’s Stray Reflections this week explores the correlation between the VIX and the Global Risk Index.

What is Volatility Telling US?

VIX vs Geopolitical Risk Index (rhs)

Source: Bloomberg, Federal Reserve Board, Goldman Sachs

Is VIX is a poor measure of risk?

Despite rising geopolitical risks and lofty market valuations, the VIX Index has been recording new consecutive lows. In the past two decades the VIX has closed below 10 on only 11 occasions, and 7 of those occasions have been during the past month. Jawad rightly asks, ‘Are we going to see policy uncertainty decline and volatility stay lower for longer, or are we about to enter a higher volatility regime?’

Volatility tourists?

JP Morgan’s Marko Kolanovic sees the death of the human investor as one of the key drivers of declining volatility. Only 10% of trading volume is currently derived from fundamental discretionary trades. Quant strategies and ETF algorithms are accounting for most of the trading, and their setup represses volatility. This happens because many of the quant strategies follow the same big-data and trend-following factor-based approaches. Volatility has been trending so low that yield-seeking ‘volatility tourists’ are joining in the party, seeing the low VIX readings as a chance to gain some yield in an apparently benign macro environment.

Show me the volatility!

To put it another way, it is quite possible that the sheer weight of money currently flowing into short volatility positions, the implied central bank put, and the rise of passive investing and quantitative funds may be clipping potential volatility. Taking a different slant on our recent featured piece from 720 Global, these forces are making the graph on the left look more like the one on the right;

Source: 720 Global

What that means is that the volatility of actual returns is increasingly resembling a random walk!

OK, I sort of get it – but what’s the big deal about volatility?

Here we must cede to a master class from Chris Cole of Artemis Capital, whose ‘Volatility and the Allegory of the Prisoner’s Dilemma‘ is truly a piece of essential reading for any investor. If you want to get a handle on this crucial concept, you need to watch Chris’s Realvision TV interview. One of his key mantras is this:

“Risk cannot be destroyed; it can only be shifted through time and redistributed in form.”

Currently, suppressed volatility is merely storing up risk for the future, explosively; and the principal reason for this is that market participants believe central banks will be there to backstop any future random events that would otherwise cause significant stress in the market. Of course, this unwavering belief invites moral hazard and is driving the trade in shorting volatility. Central banks are in effect driving up the occurrence of apparently ‘everyday’ events and pushing out tail risk:

Source: Artemis Capital, Bloomberg

The key takeaway here for investors comes when Chris says, ‘Peace is not the absence of conflict.’ A simple way of thinking about this is that the active conflict between bulls and bears discovering prices in the market each day is for now being drowned out by the waterfall of cheap money pouring down from central banks. But the bulls and bears are still there – waiting.

Here’s the bottom line.

When a risk event occurs that a central bank can’t or won’t step into, the volatility tourists are likely to be ruined, and the markets will be primed to for severe dislocations in pricing – something which the quants and algos aren’t programmed to navigate.

Staying Ahead

There isn’t time each week to discuss everything that is going on in markets. Here we piggyback on previous RVP Weekly Hack talking points and let you to explore some stories further.

Who hit the bid? The SNB did.

If you need a sign of the times, check out the breakdown on the NASDAQ holdings of the Swiss National Bank. As the SNB fights to reinvest its vast foreign exchange reserves, it has become a large buyer of US tech stocks. In fact it now owns 3.75% of Apple and 3% of Amazon!

In the first quarter the SNB increased their holdings of US equities across the board by ~25% – hardly selective buying. It seems some central banks are in fact propping up the markets in quite a direct fashion. When we think about the meteoric growth of passive investing, we need to consider that ETFs may not be the only price-insensitive buyers – there are institutional ones, too.

Tech companies make ripe pickings.

Are US regulators now looking to initiate trust-busting moves against the big tech companies? With the likes of Amazon and Google becoming increasingly dominant in their chosen fields – and choosing new fields every week – the motivation and incentives to increase regulation of these sectors is obvious.

There is a geopolitical angle here. In the period following the GFC, the US extracted a number of fines from European banks that needed to shore up their finances, whilst the EU engaged in various trust-busting activities against the likes of Facebook and Microsoft. Think of this as a kind of modern resource nationalism.

Are the US regulators about to turn on their own?