Thursday, August 20, 2015

The Maestro's Dire Warning on Bonds?

Greg Robb of MarketWatch reports, Greenspan warns about bond-market bubble:
Former Federal Reserve Chairman Alan Greenspan is sounding the alarm about a bubble that he believes is forming in the bond market.

In two television interviews in recent days, Greenspan said interest rates could shoot higher and derail the economy when the bubble bursts.

The former Fed chairman says the current situation in the bond market is comparable to what happens in the stock market during an equity bubble.

Noting that stock-market bubbles are typically characterized by extreme price-to-earnings ratios, Greenspan said extremely low yields are telling a similar tale for bonds.

“If you turn the bond market around and you look at the price of bonds relative to the interest received by those bonds, that looks very much like the usual spread which would concern us if it were equities, and we should be concerned,” Greenspan said in an interview with Fox Business Network.

In an earlier interview with Bloomberg Television, Greenspan said it was appropriate to be very afraid of the bubble. He said the bond market price-to-earnings ratio was at an “extraordinary unstable position.”

Greenspan said “normal” interest rates have always been in the 4% to 5% range.

Yields on the 10-year Treasury have been below 4% since the summer of 2008. The yield is up slightly to 2.217% in Wednesday morning’s trade.

“We have pressed the interest rates well below normal for a protracted period of time and the danger is they will come up to back up to where they have always been,” the former Fed chairman said.

“There are two possibilities. Either we move slowly back to normal, or we do it in a fairly aggressive manner. History tells us it’s the latter which tends to be more prevalent than the former,” Greenspan said.

The market impact will be “not good,” he said.
In an interview with MarketWatch last year, Greenspan said that when bubbles emerge, they take on a life of their own.
Add the Maestro to a long list of financial gurus (and pension fund managers) who are completely wrong when it comes to the bond market and why yields are at record lows and will head even lower.

When it comes to the bond market, I simply don't pay attention to Greenspan, Paul Singer, Carl Icahn or anyone else claiming the bond market is in a bubble and that bonds are the bigger short. Good luck with that trade, many hedge funds have gotten wiped shorting JGBs in the last twenty years and many more will get annihilated shorting good old U.S. bonds (TLT) in the next twenty years.

In fact, Ellie Ismalidou of MarketWatch reports, 10-year Treasury yield falls to lowest level in over two months:
Treasury yields declined Thursday for a second day, trading at their lowest level since May 29, as traders take a more dovish interpretation of the minutes from the Federal Reserve’s July meeting.

A continuing slump in oil prices, with the September contract closing in on $40 a barrel, along with growing concerns about the disinflationary effects of China’s economic woes on the U.S. economy also weighed on Treasury yields.

While the content of the Fed’s minutes was mixed, with positive growth comments but evident uncertainty on inflation, “the Treasury market settled on a dovish interpretation,” said Jeff MacDonald, director of fixed-income strategy for Fiduciary Trust Company International.

That pushed yields lower both after the release of the minutes Wednesday afternoon and overnight. The decline persisted Thursday morning, after the Labor Department said the number of people who applied for U.S. unemployment benefits in mid-August rose for the fourth straight week. Even so, the number remains at a low level, which indicates the labor market is still improving.

The yield on the 10-year Treasury declined 2.1 basis points to 2.108%, the lowest point since May 29, according to Tradeweb. The yield on the two-year note inched 0.9 basis point higher to 0.666% and the yield on the 30-year bond shaved off 3.7 basis points to 2.782%, its lowest level since May 1.

Treasury yields fall when prices rise and vice versa.

The yields on short-term Treasurys rose slightly because they are more sensitive to rate-hike expectations. An interest-rate hike in September is still on the table, but its market-implied probability was reduced Thursday morning to 36%, while a move in December was marked down as 66% probability, according to data from London Capital Group.

Conversely, yields on long-term Treasury maturities were pulled down by declining inflation expectations and the concerns of the ripple effects on the U.S. economy of the Chinese yuan devaluation and emerging markets’ underperformance.

“The basic worry here is that the U.S. might soon be importing deflation,” MacDonald said.

Government bond yields declined in the eurozone as well, as European stocks slid and investors sold equity in favor of safer assets, like bonds. Investors also welcomed the news that Greece received its first tranche of bailout money from the European Stability Mechanism and repaid on Thursday morning 3.4 billion euros ($3.8 billion) to the European Central Bank.

The yield on the benchmark German 10-year bund declined by 5.3 basis points to 0.584%.
My regular readers already know my thoughts on the bond market. I think the Fed has a deflation problem which has just been exacerbated by China's Big Bang. In fact, China's currency moves may spell the end of Greenspan's ‘conundrum’.

Moreover, I agree with the bond king's dire warning and think he's right, the Fed would be making a grave mistake raising rates as oil prices risk falling below $40 a barrel, China's economy is slowing considerably, and with junk bonds (HYG) at a four-year low.

As far as stocks, they are now following the bond market's lead, worried about deflation coming to America. The selloff in stocks is a normal reaction as asset allocators take money out of risk assets and into bonds. Remember in times of crisis or extreme uncertainty, everyone runs to safe haven assets, especially U.S. bonds.

But I wouldn't read too much into the fear and hysteria right now. Why? Because central banks around the world are in hyper accommodative mode and there is plenty of global liquidity to drive risk assets much, much higher. Bonds are still in a trading range and stocks will shoot up on the first sign of global growth or if the People's Bank of China surprises us with a big rate cut in the next few weeks (my hunch is it's around the corner).

As far as all these gurus warning you of a big bubble in bonds, please keep in mind these six structural factors (I added technology to my list) which are deflationary and bond friendly:
  • The global jobs crisis: Jobs are vanishing all around the world at an alarming rate. Worse still, full employment jobs with good wages and benefits are being replaced with partial employment jobs with low wages and no benefits.
  • Demographics: The aging of the population isn't pro-growth. As people get older, they live on a fixed income, consume less, and are generally more careful with their meager savings. The fact that the unemployment rate is soaring for younger workers just adds more fuel to the fire. Without a decent job, young people cannot afford to get married, buy a house and have children.
  • The global pension crisis: A common theme of this blog is how pension poverty is wreaking havoc on our economy. It's not just the demographic shift, as people retire with little or no savings, they consume less, governments collect less sales taxes and they pay out more in social welfare costs. This is why I'm such a stickler for enhanced CPP and Social Security, a universal pension which covers everyone (provided governments get the governance and risk-sharing right).
  • Rising inequality: The ultra wealthy keep getting richer and the poor keep getting poorer. Who cares? This is how it's always been and how it will always be. Unfortunately, as Warren Buffett and other enlightened billionaires have noted, the marginal utility of an extra billion to them isn't as useful as it can be to millions of others struggling under crushing poverty. Moreover, while Buffett and Gates talk up "The Giving Pledge", the truth is philanthropy won't make a dent in the trend of rising inequality which is extremely deflationary because it concentrates wealth in the hands of a few and does nothing to stimulate widespread consumption (I know, we can argue that last point but for the most part, you know I'm right).  
  • High and unsustainable debt in the developed world: Government and household debt levels are high and unsustainable in many developed nations. This too constrains government and personal spending and is very deflationary.
  • Technology: Everyone loves shopping on-line to hunt for bargains. Technology is great in terms of keeping productivity high and prices low, but viewed over a very long period, great shifts in technology are disinflationary and some say deflationary.
Keep these six structural factors in mind the next time you hear someone warning you of the bubble in the bond market and that rates are going to shoot up. I say bullocks! If rates shoot up, it will kill the U.S. and global economy and ensure half a century of debt deflation. 

Below, former Federal Reserve Chairman Alan Greenspan discusses his outlook for the economy and markets with Fox Business's Trish Regan. Interestingly, Greenspan rightly notes the economy is "extraordinarily sluggish" but he goes on to warn of a bubble in bonds. I respectfully disagree with the Maestro and other financial gurus warning of such a bubble.

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