It should be crystal clear to everyone that after 10 years of the most accommodative monetary policy in the worlds history the bond market is significantly overpriced. The bond market still has little to no yield (negative yields in some countries) to offset the abundance of risks – liquidity, duration and spread risks to name a couple.
After 10 years, there are managers and firms whose success is in large part to risks taken in one trade – to be long fixed income and front run central bank policies. But someone forgot to tell them this trade is over. Large balance sheets continue to trade the bond market in a monopolistic, high volume basis hoping for some large issues to drive yields lower and generate pricing gains to offset such limited yields. If investors are hoping for an economic slowdown, lower levels of inflation, geopolitical risk or even a government shutdown to help drive yields, maybe they shouldn’t be in the trade to begin with.
These are the bigger fool theory motivators to lower yields. Yields are now lower than prior cycles of recession, depression, war or pretty much any other risk this country has ever experienced. You can experience any and all of these risks and still have a probability yields shoot higher, not lower.
But some say inflation is slowing down and that must be good for bonds. Normally bonds trade 200 to 300 basis points – or 2 to 3% above the level of inflation. Since inflation is currently around 2%, inflation has to go to -1% to bring bonds somewhat close to fair value. With health care and housing costs jumping and expected to continue to show above average price increases, the chances of deflation – even with all the lower biased adjustments our inflation statistics go through – is minimal.
Comically, others say the debt ceiling debate is a source of volatility so own bonds for the flight to quality trade. So we reach our debt ceiling and have difficulties paying our bills – and that’s good for bonds???
It’s apparent that the Fed and other notable officials see the potential of a bond bubble deflating rapidly and the potential impact on the real economy. They have been trying to deflate it slowly by adjusting the Fed Funds rate off of zero and announcing a reduction in accumulated balance sheet. This week, the NY Federal Reserve President William Dudley said that he expects another Federal Funds rate increase this year. And Alan Greenspan, the former Federal Reserve chairman, has continued to express the risks to the markets from the bond bubble that has not corrected.
Sadly, bonds have yet to respond. Should the Fed be doing more to prepare the markets? They talked and manipulated yields lower with unprecedented Fed policy. Should they have been doing the opposite years ago when the systemic risks were corrected? The Fed wants to be the life of the party, but not the chaperone. Since they have refused to take the punchbowl away from the party in a reasonable amount of time, the hangover is going to be a bad one this time.
by Michael Carino, Greenwich Endeavors, 8/16/17
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 yield