Thursday, August 29, 2013

From Bond Apathy To Bond Panic?

Yves Lamoureux of Lamoureux & Co. wrote a comment on ETF Daily News, From Bond Apathy to Bond Panic:
We have been glad this year to be on the side of the bull camp. Our job has been an easy one as we pursued the long side of stocks. We remain bullish despite raising big amounts of cash many weeks ago. We think we can redeploy money shortly once we feel the corrective phase is over.

It has been a much different story on the income side. One that shows only the start of something much bigger. We did forecast long bonds to drop to a yield of 2.5%.

For us that was the marker both in time and price that satisfied our interpretation of the end of the bond bull market.

It is our opinion that we are just in the first leg up in rates. Once completed we favor a correction that can last for a little less than a year. The second wave, we feel, will be as large as this recent move. This is why late last year we urged to look at a new asset allocation system based on credits only. We felt that rates would be at 3.5% mid year 2013 and a target of 4% year end 2013.

We have had this scenario in mind for many years as past episodes rhyme in time. Our work is both based on comparative money velocities and behavioral economics. We tend to think that fear and greed are always the same. They tend to repeat more frequently than market theory allows us to believe.

Bond Apathy

In recent presentations, we are amazed to observe the level of apathy toward the recent action of the bond market. It does match up behaviorally speaking with shock and the lack of preparation.

Investors have convinced themselves that rates are staying low for a prolonged amount of time. Of course this conviction will not be proved wrong rapidly. Over time, as we have suggested, money will leave the bond market to head to the safety of a term deposit at a bank.

Having been proved wrong twice about stocks makes the return back for most impossible.

The great difficulty in this environment will be the lack of perceived safe alternative. It is also why midterm we are very bullish on gold even if we have avoided it all year long.

We think there are many pitfalls ahead that people will not avoid. We prefer to stick to being long indices as opposed to stock picking.

Rising rates will reveal the extent of debt levels. It first will be marked by companies cutting dividends. Bankruptcies will follow. It will be harder and harder to perform with the benchmarks.

Being long an index also has a positive survival bias. Bad stocks are replaced with good ones. The odds are in your favor with patience.

It is not the same say in the case of a bond fund. As rising rates will pressure your investments lower and lower. Doing nothing is sure to undermine your strategy and goals.

Dividend stocks are as much in a bubble as bonds are. We think its best to avoid income all together.

This will be a time of reflection. Some investors are not meant to be in the market. We expect a mass exodus of money that will be moving back to bank accounts.

Of course it is not what most in the financial business would like to hear. Markets are markets and they tend to behave in a certain predictable way.

The key to some of our future forecasts come from the inversion of the behavior in the treasury market.

We have been great believers in using treasuries as stock hedges in a portfolio.

We think this era is over as we have predicted well over a year ago. We are of the opinion that treasuries will revert to a positive correlation with stocks.

They will go up and down in price with stocks.

This is far from expected behavior of the last decade when treasuries rose in price when stocks fell.

Emerging market implosion

We read with astonishment that deflation is over. The sudden drop in both emerging market currencies and stocks is testament to further aerial bombs we suggested would happen recently.

We are in complete disagreement over this topic as deflation shocks being short and fast creates lasting disinflation

The wipe outs are dramatic in many cases. Caught by surprise many have been.

Where people now see a bust credit cycle we see opportunity. The flow of hot money had created huge imbalances and a perception of superior fundamentals. The king is now naked.

We are taking a hard look at re-balancing our cash into some of those interesting emerging markets.

It reminds us of European markets that nobody got interested in because of fear. Recent positives on Europe had us unload these plays at much higher prices than a few months ago.

Interesting times indeed!
These are interesting times and it's critical to understand whether we are in the midst of a prolonged bear market in bonds where rates continue to climb higher. Rising bond yields will continue to hurt interest-sensitive sectors of the economy and give cyclical stocks the advantage this year, say equity strategists on both sides of the border:
"Most interest-sensitive assets/sectors have been hit hard in the past few months, and although a rebound from oversold levels is possible in the short term, we continue to believe the uptrend in bond yields will hurt their absolute and relative performance," said Hugo Ste-Marie, small-and mid-cap analyst at Scotia Capital. "We continue to prefer cyclical plays." ...

"After a few years of strong outperformance, dividend payers' valuation was getting rich relative to non-payers, and with bond yields rising, the premium relative to non-payers is likely to compress further," Mr. Ste-Marie said.

He added he sees no reason for this trend to change any time soon, and he continues to view cyclicals as outperformers over the next year.

"Further normalization in bond yields could accelerate the Great Asset rotation and equity portfolio realignment toward more economically sensitive sectors," he said.

Tobias Levkovich, U.S. equity strategist at Citigroup Global Markets Inc., said there is very little historical evidence as to what impact the Fed's tapering may have on stock prices. But past periods of rising bond yields may shed light on how investors should be positioned.

He said the past impact on stock prices after the first 100 basis points of higher 10-year treasury yields shows that cyclicals have generally outperformed defensive names.

"Energy looks most rewarding, while the various consumer staples sector groups typically underperform, as do health care and transportation stocks," he said.

"Given soaring biotech names, we suspect that backing off these high flyers makes sense at this juncture. Similarly, utilities and telecoms do not look like profitable trades either, which means there are many mixed messages from a macro perspective and single-stock picking may be needed to get things right."
And rising bond yields have hit emerging markets hard, prompting Robert Samuelson to comment, Pop goes the 'emerging-market bubble':
To the extent there was an emerging-market "bubble," it has popped. Yesterday's conventional wisdom is not today's. Economic policies turned out to be not so sensible -- or sustainable. India's inflation is running about 10 percent, and its budget deficit is about 8 percent of the economy (gross domestic product). Contrary to widespread expectations, commodity prices have not inexorably climbed. Economic growth has disappointed. In 2012, Brazil's GDP grew only 0.9 percent, down from 2.7 percent in 2011 and 7.5 percent in 2010. The China story is similar: Growth has slowed, policies seem less sound.

Global investors' reappraisal was apparently triggered by the possibility that the Federal Reserve would reduce its $85 billion of monthly bond purchases. This would mean less money to prop up stock prices around the world, including in emerging markets. Brazilian officials and some others complain that Fed policy whipsaws them: first, an inrush of money fosters easy credit and higher stock prices; then, an exit of funds does the opposite. Fed actions inevitably cause investors to re-evaluate their portfolios, says Ubide. He also rates Turkey and South Africa as vulnerable to shifting investor sentiment.

Still, Ubide and many economists doubt a doomsday outcome. "There is no serious risk of a major global crisis," says Subramanian. That could happen if uncontrolled sell-offs around that world exhausted countries' foreign-exchange reserves (mostly dollars) that ultimately enable them to import. Global trade and production would plummet. By contrast, says Subramanian, today's market turmoil reflects an unavoidable adjustment to more normal Fed policy. In a report to clients, Capital Economics, a consulting firm, says emerging-market countries have defenses against a broader crisis: high foreign-exchange reserves; low foreign-currency debts; more flexible currencies.

All this sounds reassuring -- and probably is. But nagging doubts remain. Every major financial crisis of the past 20 years has begun with some relatively minor event whose significance seemed isolated: weakness of the Thai baht in the summer of 1997; trouble in the market for "subprime" U.S. mortgages in 2007; Greece's misreporting of its budget deficit in 2009. Could this be "deja vu all over again"?
It could be deja vu all over again and an emerging market crisis or slowdown is disinflationary and will ultimately mean lower bond yields. But for now traders are focused on shorting bonds to profit from Fed tapering.

The backup in yields has caught many investors off guard but it's worth taking a step back. In his article written earlier this month, Treasuries: Are We Watching A Bubble Burst?, Martin Tiller notes:
As 10 Year Note rates have risen and prices fallen ( the i-Shares 20+ Year Treasury ETF, TLT, has lost 16.2% since the highs in late April) bond investors have taken a serious hit, something for which the aforementioned 30 year bull market has left them unprepared. If we accept, however, that the recent move is simply a normalization of the Treasury market and represents expectations of moderately higher inflation to come, then the worst is over, and from here the positives of the move outweigh the negatives.

If this is the reason for the recent spike in yields it is unlikely to continue much longer, as I don’t think many expect real raging inflation, and the exit from what was a very crowded space in the years following the recession can continue in an orderly manner. This cash that is released from bonds will seek a home, and in even a mildly inflationary environment, stocks will look like a good bet. This move, then, is natural and needed. It will enable real interest rates (after inflation) to return to the positive, and contribute some upward pressure to the stock market. All is for the best in the best of all possible worlds!
And Roger Webb, investment director at SWIP and co-manager of the group's Strategic Bond fund, explains why the bond bubble won't be allowed to burst:
It is worth highlighting that tapering of QE is not tightening, but loosening less, and this first step in changing policy is because the world – or the US at least – is getting better. Similarly, we are sure that if the US economy slows once more, the medicine will be administered again.

Where does that leave markets? The central banks' sponsored asset bubbles created over the past few years have generated some good returns for bondholders and shareholders alike, but now are suddenly worrying about what’s next.

Consensus views have quickly become that bonds are a bad place to be as yields have to rise. We feel sure they will do so over time, but are less sure they are going to in the near-term.

Inflation remains subdued; the global growth outlook is uncertain, especially in developing markets; and the on-going risks from the periphery still mean that "safe haven" assets like Bunds and gilts have a place for some investors.

On top of that, pension funds also in the UK and Europe have an ongoing structural demand for investment grade bonds – both sovereign and corporate.

As we have said before, even in the US where growth is more robust, policymakers will be keen to control yield levels to some degree given the negative impacts of a sharp rise on both the consumer and banking sectors.

The bond bubble may be nearing its end and will be slowly deflated, but it cannot be allowed to burst. Too many parties with too much to lose are exposed to longer-dated bonds so the path to higher yields will most likely be a longer one than the early summer volatility spike suggested.
Indeed, the path to higher yields will likely be longer than what most investors expect. Brian Romanchuk, a former senior quantitative analyst at Caisse's fixed income group, wrote an excellent blog examining whether Treasury bond yields will stabilise here. I will let you read his analysis but he concludes:
...although one could argue that the forward rate might seem relatively low compared to a longer history, in that past history forward rates were comically high when compared to subsequently realised rates. The amazing bond returns of the past decades were not the result of a "bubble" – they were the result of bond yields being badly priced, with an unsustainably large risk premium.

Consideration of implied forward rates thus seems to indicate that there may be enough of a risk premium in bond yields currently to absorb good economic and tapering news, at least until actual rate hikes are on the table. With the consensus for rate hikes still being some time in 2015, it seems that it may be somewhat early for the market to take the rate hike threat too seriously.
Brian is one of the smartest and nicest guys in the industry. Worked with him at BCA Research and at the Caisse. He really knows his stuff and unlike most quants, he is well read on economic history (can tell you all about Minky's moment and debt deflation). He's now a consultant - blogger and I want to plug his blog, Bond Economics. You can reach him via the blog where he has a contact form.

Why did I write a comment on rising rates? Because some pretty smart people, like Leo de Bever, have been warning investors of the storm clouds ahead, calling the top of the bond market way before other investors. Commenting on AIMCo's record results in 2012, he said: “The biggest issue we foresaw last year was the end of the bull market in bonds, and that’s coming on in spades this year.”

But this comment was also written to give my readers food for thought. How will rising bond yields impact interest-sensitive stocks? Is the dividend bubble over and should investors shift into cyclical stocks? Are we on the cusp of an emerging market crisis and how will will this impact bond yields? Will the bond bubble be allowed to burst or will it slowly deflate? Have rates stabilized here?

These are all critical questions with profound implications for retail and institutional investors. And while my focus has been on public markets, these issues will impact private markets too. Pension funds that are broadly invested in private equity, real estate, and infrastructure are examining their portfolios to determine the risks and opportunities of a backup in bond yields.

Having said this, think markets have gotten way ahead of themselves when it comes to rising rates. The upcoming jobs report will be critical but I agree with Brian, the implied forward rates seem to indicate that there may be enough of a risk premium in bond yields currently to absorb good economic and tapering news.

Below, as PIMCO's Bill Gross declares a war to defend bonds, others have different views. Steve Auth, Federated Investors Global Equities, and Ron Kruszewski, Stifel Nicolaus, discuss their views on the bond market. "We think we're in a bond bear market," says Auth.