Tuesday, August 30, 2016

Exposing Bond Bubble Clowns?

Ron Rimkus, CFA, wrote a comment for the CFA Institute, Is There a Bond Market Bubble?:
What is a financial bubble? A financial bubble occurs when the market price of a security or a group of securities increases well beyond the point where the long-term benefits of ownership fail to compensate the investor for the costs — market price, trading costs, liquidity, etc. — and risks of ownership.

Which brings us to the bond market.

If the results of a recent CFA Institute Financial NewsBrief poll are any indication, at least some of the global fixed-income market is in bubble territory. So if respondents agree with the above definition, then 87% of the 815 participants believe that owning at least some types of fixed income no longer makes sense.

Yet clearly many investors do own these bonds. What explains this dissonance?

The global policy response since the financial crisis of 2008 has been massive and unrelenting. While the US Federal Reserve has (at least for now) ceased its quantitative easing (QE) operations, it has struggled to return interest rates back to normal levels or reduce its balance sheet back to its former size. Japan has maintained QE at approximately 15% of its GDP for some time, and recently hinted that it may escalate it in the near future. In March of this year, the European Central Bank (ECB) increased its QE program from €60 billion to €80 billion in bond purchases per month.

All of this bond buying by central banks has been intentional, of course. By providing a bid under bonds, they have lifted bond prices and reduced interest rates. In many cases, like in Europe and Japan, this has created negative interest rates. The ECB now “charges” a negative interest rate of 0.4% for banks that borrow from the ECB. Of course, this means that the ECB is actually paying banks to borrow money.

In June, Germany became the second nation to issue a 10-year bond with a negative yield. In fact, according to a recent report by Bloomberg, more than 80% of German government bonds have negative yields. In Japan, 20-year bonds are now below zero. This is making it hard on global bond fund managers where Japanese bonds typically comprise 20%–35% of the global bond indices. (How would you like guaranteed losses on one-third of your holdings?)

Globally, over $13 trillion of the global bond market is now negative. “It’s surreal,” says Gregory Peters of Prudential Fixed Income.

Of course, this backward, underwater, upside-down world is just fine with some people. Certain investors suggest that negative yields are a “Sign of Prosperity.” And some bond managers have even figured out clever ways to make money in this market. For instance, PIMCO is buying negative yielding Japanese bonds and using swaps to lock in exchange rates, effectively quadrupling the yield on long-only US bonds of similar duration. So, they are buying negative yielding bonds, but using savvy finance skills to transform it into positive yield.

And that’s really the game, isn’t it? Low and negative rates are forcing legions of investors to seek higher yield, and in doing so, they are taking on more and more risk. Maybe it’s because they know that the central banks will maintain these policies despite potentially adverse consequences in the long term.

So, what do CFA Institute Financial NewsBrief respondents make of the fixed-income market today? As noted (click on image above), 87% of respondents see the bond market in bubble territory in some way. In other words, they believe that bonds today fail to compensate investors for the costs and risks of ownership.

The largest segment of respondents (30%) believe all bonds are in bubble territory. Another 24% see a bubble in sovereign bonds and at least one other class of fixed income. Somewhat surprisingly, only 14% of poll participants think high-yield bonds are over-inflated. And roughly 13% don’t see a fixed-income bubble anywhere. Perhaps this cohort should have attended the Financial Analyst Seminar in Chicago where Edward Altman suggested that “the benign credit cycle is in ‘extra innings‘” — an ominous sign of a coming default cycle.

Most investors recognize the vast power that central banks wield but, by and large, disagree with the wisdom of their policies. In order for the world to return to market pricing of bonds, there has to be a catalyst. The power of the central banks must be more than offset by something else. There has to be a fundamental wave — either positive or negative — to counteract it, or a political wave to change it.

Until then, investors will remain adrift on an ocean of negative yields.
There are so many things wrong with this comment but before I criticize it, Gerard MacDonell, my former colleague at BCA Research eons ago and former economist at SAC Capital (yes, THE SAC Capital) wrote a snarky blog comment, Don’t get a CFA or take BI seriously:
I am trying to tidy up this blog to take out the self-indulgent, puerile stuff and to leave only what strikes me as having some substance. I hope that airbrushing does not seem too Soviet to you, and I feel a pang of guilt compelling me to be direct about it.

Besides the guilt, there is another problem. I just don’t seem to have the discipline not to get sucked into expressing outrage over the crazy but unimportant stuff I see on the internets every day. They keep dragging me back!

For now, my solution is occasionally to let it rip and then to just delete it, once I smarten up and realize, well it seemed like a good idea at the time. Comparing Theresa May with Brit Marling would be an example. I undelete that, probably temporarily, so you can see what I’m talking about.

With that in mind, I thought this piece on Business Insider, almost inevitably BI, was a bit of a siren call striking while my hands were not tied to the mast. The article, which originally appeared at the CFA Institute, claims that there is a bubble in bonds because 87% of people surveyed say there is a bubble there “in some way.” I will get to whether such a claim is self-defeating on contrarian grounds in a second.

But first, they didn’t, did they? They didn’t just add up all the percentages that weren’t “None of the Above” to come up with their 87%. An institute whose main mission is financial numeracy would not sponsor such innumeracy. Would it?

Let me get about my Casio solar-powered calculator, available at Duane Reade. Yes, they did, although apparently they used the unrounded figures. And BI published it. No jury would convict me for breaking my promise to avoid the puerile to discuss this. Wow.

What about the super-obvious idea that an asset class cannot be in a bubble if everybody thinks it is. That is what originally raised my ire here. But I think my original impulse is wrong, and that this is the one area where the BI article was not far off base.

I like Richard Thaler’s definition of a bubble, which is far superior the conclusory silliness offered at the top of the BI article. Thaler has said — and I assume he still says — that an asset class is in a bubble when people believe it is overvalued but are invested on the expectation that it will become more overvalued based on the the stupidity of others. When the price is set by the greater fool theory, it is a bubble.

What I love about this definition is that it is at least in principle measurable. You can just ask people if they own and why they own, as Thaler has. Sure people lie and don’t know their own motivations, so your surveys may be wrong. But with Thaler, at least we know what we mean. The concept is, in principle, measurable. Plus Thaler applied this conception brilliantly to the NASDAQ bubble, as I have mentioned on another occasion.

So I think it is actually ok to claim that bonds are in a bubble because everybody believes they are. It is against my first instinct, but my first instinct is wrong, I think.

The problem is more that, umm, not everybody believes they are in a bubble. Indeed, according to the CFA guy, the vast majority of people believe they are not in a bubble. So of course, naturally, the story’s main point is the exact opposite.

BI, you’re doing a heckuva job! “The future of media,” as its owner never tires of saying. Maybe that guy didn’t change so much after all. Separate discussion.

Also a separate discussion is that Bloomberg seems to be competing on dumb with BI, because they too need the clicks. It is like Gresham’s Law applied to journalism. Of course Bloomberg has some non-stupid to balance it out. For example, there is Noah Smith.

Here is my view, for whatever it is worth. I am not a fan of Jim Grant usually, although I appreciate his sense of humor. He once opened a speech with the claim that he has been covering what the bond market would not do for about twenty years now. Good one.

He also says (or recently said) that Treasurys currently offers the exact opposite of the financial unicorn: “return-free risk.” That seems right and gets style points. Smartest guy in New York, according to a survey.

You can say to bonds meh, without claiming they are a bubble! And besides, whatever happened to just believing the price might be wrong because it discounts a fundamental premise that will end up being wrong. Not every price about to change reflects a bubble.

Plus the term premium, which is set by QE, as we all know, is now more negative than it has ever been, as QE gradually unwinds. Snigger snigger.*

Snark aside, the term premium is meant to be the expected excess return. And it is now negative. It seems you could be short or — more prudently — just interested in other things.

* Goldman has made the point that market for duration risk is global. As I read that, they are assuming that many investors have a preferred habitat in a type of trade, rather than in a currency of denomination. I am very skeptical that QE does much, but I think that is actually a pretty fun thought, and totally plausible. If it is right, then I can’t really declare victory on the grounds that US QE is unwinding and yet the term premium keeps sinking. So my snark would be misplaced. I just think GS overstates the scale of these effects, in part by conflating rates guidance (explicit and implied) with the supply effects of the government bond purchases themselves. This ain’t over. Somebody should add up all the 10-year equivalents not be taken down by QE, globally or in the OECD. Summers et al did it for the US, which I loved, because it made my point in spades. But other smart guys like GS should do it globally. The idea that global QE has made core market duration scarce assumes facts not in evidence, although it might end up being true. It would be fun to see the numbers.
Alright, Gerard could be a real jerk sometimes but he's right, this talk of a bond bubble is ridiculous as are those CFA and Business Insider articles.

Another former colleague of mine from BCA Research and the Caisse, Brian Romanchuk, publisher of the Bond Economics blog, shared these thoughts with me on the article above:
For most people, a "bubble" is a bull market that they were on the wrong side of. There are technical definitions, and bonds have no real hope of qualifying for those definitions. Does anyone believe that interest rates can be arbitrarily negative (which is what hyperexponential price movements would require)?
Brian and I actually spoke on the phone today and he told me that typically a bubble requires a parabolic move in prices and since he's never seen this in the bond market, it's hard to call this a bond bubble. "With rates at record lows, you can't get an exponential run-up in bond prices."

He did say that there have been bond bear markets in the past but nothing remotely resembling stock market bear markets.

We also had a lively discussion on the Fed and interest rates. Brian thinks the "level of interest rates don't really matter in this economy but if you work for the Fed, it's blasphemy to admit this". He thinks the Fed will continue to gradually hike rates and there may be some market dislocations but the real economy will keep humming along.

That's where I raised some objections. In my opinion, with China, Japan and Europe still struggling with deflation, the Fed would be nuts to raise rates and risk another emerging markets crisis and importing deflation in the US via the stronger greenback (which lowers import prices on goods).

The other point I made to him is after Jackson Hole and all the hawkish talk from Stanley Fisher and Chair Yellen, the yield curve actually flattened, a point which Charlie Bilello of Pension Partners demonstrated on his Twitter account (click on image):

Why is the yield curve flattening? Because while the short end of the curve reacts negatively to the Fed's endless chatter of raising rates, the long end of the curve only cares about inflation expectations and actually is telling you if the Fed raises rates, it will lower inflation expectations even more and risk a real recession (inverted yield curve).

Charlie also posted an interesting chart on US high yield bonds (HYG and JNK; click on image):

So, are bonds really in a bubble? Of course not. All this talk of a bond bubble makes my skin crawl! Whether it's hedge fund billionaire Paul Singer warning us that bonds are the "bigger short", or the Maestro's dire warning on bonds, or even Jamie Dimon's warning that the Treasury rally will turn into a rout, I tune off when people warn me of the scary bond market.

That brings me to the CFA article above. I have nothing against CFAs but if you're going to be covering the bond market, make sure you cover all angles properly. And make sure you understand portfolio theory and how to construct a well-diversified portfolio which protects against downside risks.

Importantly, as I've been warning for a very long time, deflation isn't dead and it remains the single biggest macro risk that policymakers and central banks are fretting over. But no matter what they do, the deflation tsunami is headed our way, and in a deflationary world, good old US bonds (TLT) will remain the ultimate diversifier even if rates are at record lows or negative.

I talk with a lot of people who are worried about bubbles in financial markets. They tell me everywhere they look, they see bubbles in stocks, bonds, real estate, venture capital, private equity and even in infrastructure.

I tell them everywhere I look I see DEFLATION on the horizon which is why I take the bond market's ominous warning very seriously and keep referring to six structural factors to explain why I'm worried of a global deflationary tsunami:
  • The global jobs crisis: Jobs are vanishing all around the world at an alarming rate. Worse still, full-time jobs with good wages and benefits are being replaced with part-time 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. Whether it's people retiring in pension poverty or chronic pension deficits forcing a huge increase in property taxes and utility rates, the pension crisis is deflationary. 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: Rising inequality is threatening the global recovery. As Warren Buffett once noted, the marginal utility of an extra billion to the ultra wealthy isn't as useful as it can be to millions of others struggling to make ends meet. The pension crisis exacerbates rising inequality and directly impacts consumption and aggregate demand.
  • 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 (think Amazon, Uber, etc.).
I know, I sound like a broken record on deflation and should give it a rest. But unlike all these talking heads and gurus warning us of a bond bubble, I've been right on my macro calls and continue to believe that global deflationary headwinds are what are driving bond yields lower and lower, and there's nothing in terms of policy to make me believe a major shift is on its way.

Quite the opposite, I'm more scared of a major deflationary crisis in the years ahead than the bursting of the bond bubble. But alas, this isn't something keeping me up at night, at least not yet.

Below, CNBC thinks you should stop worrying about the bond bubble and love the market. What does the yield curve say about economic growth? Boris Schlossberg of BK Asset Management and Jacob Weinig of Malachite Capital discuss with Michelle Caruso-Cabrera.

Also, Scott Mather, chief investment officer of US core strategies at Pimco, discusses bond market volatility and reducing risk in your portfolio. He speaks on "Bloomberg ‹GO›." Given my views on deflation being the primary risk, I don't agree with his comments on duration risk and nominal Treasury bonds.

Third, Richard Ross, Evercore ISI, discusses why he is keeping his eyes on the CBOE Volatility Index, crude and Brazil in September. The "Fast Money" traders weigh in. I agree with his comments on crude and emerging markets but don't agree with his comments on stocks (read my market views here to understand why volatility is so low and why biotechs and tech will continue to surge higher).

Lastly, an interesting discussion on BBC's HardTalk with professor Steve Keen, author of Debunking Economics, on why we shouldn't trust mainstream economists with our future.

Even though I don't fully agree with him, take the time to listen carefully to Steve Keen because he understands just how unstable the global economy truly is and how ignorant most economists are when it comes to understanding the real risks underlying our financial markets.

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