The sharp swoon in U.S. Treasury yields this month may not point to a looming economic slowdown after all.Yesterday, I discussed the new real estate chief at the Caisse and shared this:
Less than half of the bond-market’s rally in August can be explained by a deterioration in the economic growth outlook and expectations for further monetary easing from the Federal Reserve, according to Marko Kolanovic, J.P. Morgan’s global head of quantitative and derivatives strategy, in a Tuesday research note.
The rest of the bond market move was driven by non-economic factors that nonetheless have spurred demand for long-term government debt.
Market participants have complained that the speed of the bond market’s rally this month appeared overdone given the resilience of the U.S. economy. Recent data including strong retail sales and continued growth in jobs underscore the strength of U.S households that have weathered the worsening global economic growth trajectory.
Given this backdrop, investors have been asking “how much of the move can be attributed to increased recession risk versus technical flows in an environment of poor liquidity,” said Kolanovic.
The 10-year Treasury note yield has shed as much as 50 basis points this month, contributing to close to half of its year-to-date decline. The benchmark bond yield is down around a single percentage point since the start of 2019.
Falling long-term yields have pushed the 10-year yield below the 2-year note yield to invert the yield curve briefly last week. An inversion of the curve has preceded each of the last seven recessions.
Worries that the bond market was portending an economic downturn sparked the biggest one-day slump for the Dow Jones Industrial Average this year on Aug. 14.
But Kolanovic says the value of long-term bond yields as an economic signal has been somewhat distorted by technical drivers such as so-called convexity hedging, a powerful driver of the bond-market’s rally this year.
Such technical flows were highlighted earlier in March after investors rushed to refinance home loans to take advantage of the slide in long-term mortgage rates, which were pegged to long-term Treasury yields. This resulted in a wave of prepayments from homeowners rolling over their loans at lower rates.
To hedge against the risk of diminished incomes from home loans, investors of mortgage-backed securities bought Treasurys with extended maturities, pushing yields lower in a vicious circle of bond buying.
JPMorgan estimates that inflows into long-term government bonds from convexity hedging this year amounted to around $400 billion.
Thin liquidity conditions over the summer have also helped super-charge the bond-market rally.
The lack of trading was exacerbated by the sudden retreat of high-frequency traders spooked by the spike in bond-market volatility this month. Analysts say high frequency traders have become increasingly important market makers for Treasurys over the last decade.
The one-month Merrill Lynch MOVE index, which tracks the implied volatility of the 10-year Treasury yield over 30 days, spiked to a reading of nearly 90 on Aug. 16, its highest levels since early 2016.
This weekend, I posted an article on LinkedIn by Peter Osborne warning us to prepare for the coming economic hurricane. I'll let you read his article it but he rightly notes from Germany to Italy to China, there are growing worries that something big is going to crack and he ends on this ominous note:Simon Lamy was absolutely right, convexity hedging from large mortgage funds exacerbated the downward move in US long bond yields, sending bond prices up to multi-year highs:Of course, cyclical downturns of this kind, however unpleasant, are routine occurrences. What makes me truly nervous about this one is mounting global debt, which now stands at a far higher level than it did ahead of the 2008 recession.
This is deeply worrying because back in 2008, governments around the world were able to solve — or, at least, ameliorate — the problem by investing huge sums, bailing out banks and re‑floating the economy via quantitative easing (in which central banks injected new money into the system).
Yes, it worked then, but if another financial crash of that size happens, we lack the means to do it again. National balance sheets have not recovered.
And it’s not just national debt. Average UK household debt is now more than £15,000 — that’s £2,000 more than the alarming level reached in 2008.Before you jump off a cliff, however, the good news is this afternoon, I spoke with Simon Lamy, who for over 20 years was the best fixed-income portfolio manager at the Caisse.
Consider this terrifying statistic: unsecured debt stood at a £286 billion in 2008. That was unsustainable then, but today it stands at £428 billion.
The same trends are seen internationally. Last week, U.S. mortgage debt reached a record level — $9.406 trillion, according to the Federal Reserve Bank of New York — which, for the first time, surpasses the high of $9.294 trillion from 2008.
On Wednesday something sinister occurred. For the first time in 12 years, yields on long-term bonds fell below those on short-term bonds.
For the last half century, this so-called inversion of the yield curve has been an infallible sign that recession is on its way.
The terrifying truth is that world growth has been financed on a borrowing splurge for the past decade.
Simon is now running his own hedge fund and in my opinion, the Caisse should seed him with $1 billion to start a global macro fund in Montreal (I'm dead serious, not that he needs it). Not only is he brilliant, he's humble, very honest and a great trader and macro thinker.
There are two people the Caisse's Fixed Income group should have held on to no matter what, Simon Lamy and Brian Romanchuk, but alas, organizational politics and bonehead HR moves got the best of them.
Anyway, Simon told me the most significant move in bonds have happened since Mario Draghi's June press conference when the ECB stated it will do "whatever it takes to fight deflation" and other central banks including the Fed followed suit.
He agreed with me that the recent move in global bond yields was mostly CTAs who according to him "piled in front of mortgage hedgers hedging their book (buying US Treasurys) as rates plunged to new lows."
But Simon thinks too much is being made of the inversion of the US yield curve which is more technical in nature and not based on economic fundamentals.
He told me "negative yields can come to the US" but for that to happen you need to see deflation rearing its ugly head and "central banks have told you they will do whatever it takes to fight it."
Still, he did add this: "A lot of the problems around the world are structural in nature (demographics, etc.) so central banks will not solve everything by cutting rates and engaging in more QE. Moreover, negative rates will distort real estate and public markets even more and cause a bigger crisis down the road."
Right now his three highest conviction trades are:Of course, he agreed with me that if deflation eventually comes to the US, we're in big trouble and will go the way of Japan or far worse.
- Long Canadian preferred shares (reset based on 5-year Canadian bond yield)
- Long US 5-year bond/ short Canada 10-year bond
- Positioning for a steepening of the US yield curve (duration-weighted, buy 2-years, sell 10-years)
The plunge in yields hit some top bond funds very hard. Dan Ivascyn’s $130 billion Pimco Income Fund lost 1.07% since July 31 while its benchmark, the Bloomberg Barclays US bond aggregate index, gained 2.29% -- a gap of 3.36 percentage points.
Even a bond bull like me was caught off guard by the veracity of the move but some CTAs were well positioned, front-running mortgage funds as they were hedging their book, and made a killing in the process as global bond yields plunged to new lows.
This is why you need to be careful when you see parabolic moves in the bond market or any market. Typically, it's CTAs and other quant funds driving the parabolic move, leaving a lot of fundamental money managers scratching their head wondering what's going on.
The other thing Simon and I spoke about was the stock market. I told him everyone is buying US stocks because it's the most liquid market in the world and 22% of the index is made up of technology shares (XLK) that have been on fire since the selloff of the last quarter of last year:
In fact, despite the recent selloff and volatility in stocks, the uptrend in tech stocks continues. It's still the best-performing sector by far, up 27% year-to-date, far outpacing the S&P 500 which is up 16% this year (mostly owing to the huge rally in tech shares but also because of other sectors that are doing well):
We are at an important crossroad here, either tech shares pull back, hold important support levels and forge ahead to make new highs, or the rally in stocks will come to an abrupt end.
Until recently, the stock market was ignoring the bond market, but if something more ominous occurs (Italian debt crisis, China devalues, etc.), it will be impossible to ignore bonds if yields continue plunging to new lows.
Of course, everyone is telling me the credit markets are fine so there's nothing to worry about:
I'd be careful here, if something blows up, credit markets will seize up very quickly in these thinly traded markets, so I'm not using credit spreads as a gauge of future economic activity or financial stress.
The reach for yield is driving everyone to the high yield market and as long as the appetite for corporate bonds remains strong, companies will keep issuing debt to buy back their own shares, boosting their earnings-per-share and more importantly, executive compensation.
That's why I chuckled when I read that top CEOs are now saying shareholder value is no longer everything. A friend of mine put it so eloquently: "Nothing like a bunch of CEOs who have enriched themselves beyond all reasonable measures to start talking about shareholder value."
Simon Lamy asked me how much of the stock market rally is due to buybacks and I answered "an obscene amount". That's why the Atlantic calls it the stock-buyback swindle.
But as long as the Fed and other central banks do "whatever it takes" to ward off global deflation, investors will keep favoring growth over value stocks and the stock buyback swindle will continue unabated.
Capitalism must win at all cost. Period. As Simon told me: "Unlike fund managers, central banks don't have a P&L." He's right, central banks just need to keep the financial system afloat at all cost.
But Simon also understands the nature of the problem is structural and central banks cannot fix these structural problems which I outlined years ago in my comment on why deflation is headed to the US.
Governments cannot do much either, most of them are over-indebted. It's bleak, look at Japan over the last 20 years, an aging demographics has hampered growth and that cannot be monetized away.
Simon told me: "Economic growth comes for two sources: population growth and productivity." If either of them aren't growing, we're in big trouble over the long run.
That's basically why Canadian and large global institutional investors are setting their sights on Asia, especially India, to find emerging sources of growth.
That's all great as long as global deflation doesn't swamp us first and stick around far longer than we expect.
There is a record amount of negative-yielding debt outside the US, and as Simon rightly noted, "most global fund managers are just piling into Treasurys on an unhedged basis", and that too causes long bond yields to plummet more than normal.
But he said even though German and French long bonds are negative, once you factor in swap and carry costs, it's still not easy to short them and go long US long bonds on a relative basis (costs will arbitrage away and yield differential).
There are a lot of technical reasons why bond yields around the world have plummeted, and they are not all based on economic fundamentals.
That's why a lot of experts think bond market jitters are overdone, except of course if deflation rears it's ugly head. Then all bets are off and US long bonds will continue to rally like never before and we will see negative yields here (never mind what Pimco is now saying about helicopter money).
Below, David Rosenberg, Gluskin Sheff chief strategist and economist, Quincy Krosby, Prudential Financial's chief market strategist, join "Squawk on the Street" to discuss the stocks and bonds markets as recession fears loom.
Second, Jim Bianco, Bianco Research, breaks down his outlook on the bond market. Jim thinks the low in yields on US long bonds aren't in yet unless the Fed signals a 50 basis point rate cut for its September meeting.
We shall see what Fed Chair Powell has in store for us tomorrow afternoon but I'm on record stating if the Fed cuts by 50 basis points in September, stocks will sell off hard but in the meantime, they could run up in anticipation of more rate cuts.
Third, President Trump is lashing out at Fed Chair Jay Powell once again ahead of the Fed symposium in Jackson Hole later this week. In a series of tweets, the president said that while the economy is strong, Powell's lack of vision is hurting other parts of the world. Former Minneapolis Fed President, Narayana Kocherlakota, former president of the Minneapolis Federal Reserve and economics professor at the University of Rochester, joins"Squawk Box" to discuss.
Lastly, Ray Dalio of Bridgewater Associates, says in the next few years, there will be "a turn for the worse" in the global economy and an environment with excess capacity, debt restructuring and political issues. He now sees a 40% chance of recession prior to the next election and says central banks will continue cutting rates as long as the yield curve is inverted.
Of course, Ray is talking up his book as he's long bonds and gold, but I also embedded an interview he did in September 2018 with Bloomberg's Erik Schatzker explaining his expectations for the next economic downturn.Well worth watching this interview again.