Cracks In The Bond Market?
One of the pillars of 2016’s record-setting global bond rally is starting to buckle.At this writing on Friday afternoon, US stocks are getting slammed hard, the USD is rallying, crude oil and gold are selling off, the yield on the 10-year Treasury note backed up to 1.67% and the volatility fear index (VIX) shot up 33% to 16.67, its highest reading since the Brexit vote back in June (click on image):
Japan’s sovereign debt is suffering its worst rout in 13 years, handing investors bigger losses over the past two months than any other government bonds amid speculation the Bank of Japan plans to change its asset-purchase strategy. The reversal is spurring concern the second-largest debt market is the vanguard for a broader selloff. DoubleLine Capital Chief Investment Officer Jeffrey Gundlach said investors should prepare for bonds to fall.
“The impact of the BOJ’s stimulus is that the bond markets worldwide are becoming one market,” said Chotaro Morita, the chief rates strategist at Tokyo-based SMBC Nikko Securities Inc., one of the 21 primary dealers that trade directly with the central bank. “If there’s a reversal of policy, you can’t rule out that it would roil global debt."
Treasury benchmark notes were little changed Friday with a yield of 1.61 percent as of 8:30 a.m. in London, based on data compiled by Bloomberg. The yield rose six basis points Thursday in the U.S., and Australian yields followed Friday by advancing 10 basis points to 1.96 percent.
In Japan, the 10-year benchmark climbed three basis points to minus 0.01 percent, rebounding from the record low of minus 0.3 percent set in July.
“This is a big, big moment,” DoubleLine’s Gundlach said in a webcast Thursday. “Interest rates have bottomed. They may not rise in the near term as I’ve talked about for years. But I think it’s the beginning of something and you’re supposed to be defensive.”
BOJ Governor Haruhiko Kuroda has been at the forefront of the global experimentation in monetary policy that’s extended a three-decade bull run for bonds and seen yields on as much as $8.5 trillion of developed sovereign debt languish below zero. Concern about what he’ll do next comes just as the Federal Reserve considers raising interest rates in the U.S., and as the deepest connections between worldwide markets since at least 2008 raise the stakes for central bankers and asset managers.
Steeper Curve
The BOJ chief said this week that a review of the current stimulus efforts due by the Sept. 20-21 policy meeting won’t result in a scaling back of easing. Still, some analysts and investors speculate a shift toward a steeper yield curve after the gap between two- and 30-year securities compressed to a record 30 basis points. Kuroda has noted that low long-term yields would hurt returns on pension and insurance investments.
Japan’s sway over global debt has increased in 2016. The correlation between securities in Tokyo and a gauge of worldwide bonds has risen to 0.86 this year, from 0.58 in 2015, according to Bank of America Corp. indexes. A correlation of 1 would mean they moved in lockstep.
Goldman Sachs Group Inc., a primary dealer in both the U.S. and Japan, warned in May that Japan could be the catalyst for the next international selloff in bonds. While there’s no immediate danger of a global spike in long-term yields amid tepid inflation worldwide, any shift in the BOJ’s unprecedented asset-purchase plan would have a ripple effect, according to Francesco Garzarelli, the London-based co-head of global macro and markets research.
Global Impact
“A change in tack by the BOJ would be felt on global bonds,” he said in e-mailed responses to questions on Wednesday.
In 2015, it was euro-area government debt that was in the driving seat for fixed-income markets around the world.
Traders were caught off guard as nascent signs of inflation and euro-zone economic growth fueled a bond rout that began in Europe and quickly spread. The 10-year German yield surged by more than one percentage point in less than two months, and the Bloomberg Global Developed Sovereign Bond Index lost more than $750 billion in market value between April 29 and June 5 last year.
Japan’s government debt has tumbled 2.3 percent this quarter, heading for its steepest such loss since 2003, the BofA indexes show. Other markets have so far fared better. The premium offered by 10-year Treasuries over similar-maturity Japanese bonds shrank to the least in 17 months this week at 156 basis points, before rebounding to 164 basis points.
All this comes after the BOJ’s decision to introduce a negative deposit rate in January accelerated a plunge in yields. That spurred a rush among Japanese investors to seek income in bonds abroad -- flows that have now started to dry up.
They sold a net 1.33 trillion yen ($13 billion) of overseas debt in the week ended Sept. 2, unloading securities for the first time since June, according to Ministry of Finance data. That was after buying 4.72 trillion yen of U.S. sovereign bonds in July, the biggest amount in ministry data to 2005 after the record 4.95 trillion yen they purchased in March.
“Japanese purchases of Treasuries have stopped temporarily,” said Hideo Shimomura, the chief fund investor at Mitsubishi UFJ Kokusai in Tokyo, which oversees about $118 billion. “Long-term yields in Japan have risen. Money will be coming back.”
Overseas buying of U.S. debt helped push 10-year yields to an all-time low of 1.32 percent in July.
Record Stimulus
Kuroda has made unprecedented use of central bank power with his package of negative interest rates along with purchases of government and corporate bonds, stock exchange-traded funds and shares in real-estate investment trusts. Any shift may fuel speculation central banks are running into diminishing returns from their use of easy monetary policies.
Old Mutual Global Investors Ltd., which oversees the equivalent of about $436 billion, says a policy change aimed at steepening the yield curve wouldn’t be surprising, even though it would come at the expense of bondholders.
“It would definitely see some pain,” said Mark Nash, head of global bonds at the London-based fund manager. “Money flows across borders. It’s all linked.”
So what's going on? Is this it? Is the liquidity rally in risk assets over as global bonds sell off and everyone braces for the Bank of Japan and the Fed to reign in their asset purchases and (in the case of the Fed) raise rates?
Interestingly, Lindsay Dunsmuir and Svea Herbst-Bayliss of Reuters report, Fed officials divided as September policy meeting nears:
U.S. Federal Reserve policymakers on Friday headed towards their policy meeting later this month divided on whether a rate rise is in the offing, with some of the permanent voting members appearing wary of supporting an immediate hike.Last Thursday, I looked into whether the Fed is set to hike rates and stated "the Fed would be nuts to raise rates in a world where global deflation is still lurking."
Financial markets had started pricing in a greater chance of a rate hike on Sept. 21 on the back of a series of hawkish speeches. After Boston Federal Reserve President Eric Rosengren spoke on Friday, odds on a rate hike in September rose to 30 percent probability from 24 percent before his comments.
After the more dovish Federal Reserve Governor Daniel Tarullo spoke, that had fallen to a 20 percent chance.
Tarullo told CNBC he wants to see more evidence of a sustained uptick in inflation toward the Fed's 2 percent target before raising rates, an oft-repeated assertion of his that immediately dampened investor expectations that the central bank will raise rates at its Sept. 20-21 meeting.
"As inflation in my view shows that it's picking up in a sustainable way... then we'd raise rates," Tarullo said, adding there had been "so many false up and downs in the past."
There are five members of the Washington-based board of governors, including Tarullo, all of whom have a permanent vote on monetary policy and ten voting members overall.
Influential Fed Governor Lael Brainard has also repeatedly advocated against raising rates too quickly amid sluggish inflation and growth in the U.S. and globally. She is scheduled to speak in Chicago on Monday, one day before the central bank's communications blackout period takes effect.
The other five voters this year are from the regional Fed banks and include Esther George, who has long supported a rate rise and dissented at the last three of the Fed's four policy meetings at which rates were left unchanged.
WILLING TO WAIT, BUT FED SIGNALS UPWARD PATH
Tarullo's comments contrasted with those of Rosengren who said the U.S. economy increasingly faces risks if the central bank waits too much longer to raise rates.
"Risks to the forecast are becoming increasingly two-sided," Rosengren said in Quincy, Massachusetts. He added that while a slowdown overseas remains a concern, the U.S. economy has proven resilient and could even overheat if Fed policy remains unchanged for too much longer.
That said, Rosengren did not say whether he expects to back a rate hike this month or even this year.
Financial markets are pricing in a December rate hike. Chair Janet Yellen said in an appearance at Jackson Hole, Wyoming, two weeks ago said that "the case for an increase in the federal funds rate has strengthened in recent months."
That view was echoed on Friday by another Fed official, Dallas Fed President Robert Kaplan, who nevertheless added that long-term headwinds to economic growth mean the central bank can afford to raise rates very slowly.
"The Fed can afford to be patient and deliberate in its actions," Kaplan told reporters in Austin, Texas.
On this last point, Zero Hedge posted a comment from Axel Merk, "It Ain't Working", where he lashed out against the Fed's failed inflation focus, stating this:
Inflation targeting isn't working. Below is a chart of market-based long-term inflation expectations for the U.S. and Eurozone (EZ). If we are not mistaken, Draghi shutters when he sees long term inflation expectations sagging; we believe former Fed Chair Bernanke would have long been tempted to resume quantitative easing (QE) looking at this chart. Fed Chair Yellen is a labor economist, so she may not be quite as glued on this particular chart. The Fed, in general, also likes to point out that there are other (survey based) measures of inflation that don't paint that bleak a picture (click on image).That chart of the 5y/5y inflation swap forward is what keeps the doves at the Fed up at night. It should also worry BOJ Governor Haruhiko Kuroda.
Why is it bad that inflation expectations are ticking downward? Isn’t your purchasing power improving when inflation is low, even negative? You might say that as a saver, but if you have debt, you might prefer inflation. Economists have figured out that workers have a greater incentive to work if inflation chips away at the purchasing power of your hard earned cash ever so slightly every year. A credit (read: debt) driven economy might go into reverse (a deflationary spiral) if inflation is too low. It’s why we sometimes state that incentives of a government in debt may be very different from those of investors.
Importantly, no matter what is going on in the Japanese bond market, there is no way the Fed will start hiking rates as inflation expectations keep sinking lower. That would be utter madness.
As far as Japanese bonds, as their yields back up, Japan's large pensions and insurance companies will be scooping them up, driving yields lower. I'm not even convinced the BOJ will curb its asset purchase program, just like I'm highly skeptical the Fed will raise rates in September.
As far as cracks in the bond market, a lot of people are getting agitated over nothing. There is no bubble in bonds but if you think so, be my guest.
What about Jeffry Gundlach and Bill Gross? What about them? They both know how to manipulate market expectations but unless you're privy to their positions, don't read too much into their public warnings.
As far as ETFs I track, it was pretty much a broad-based selloff everywhere on Friday (click on image):
The big declines however were in gold miners (GDX) and junior miners (GDXJ), Metal and Mining (XME) and oil service stocks (OIH) but all around, Friday was an ugly day. Even bonds (TLT) sold off.
The next couple of weeks going into the BOJ and Fed meetings should prove very interesting but I think a lot of edgy investors are fretting over nothing, including so-called cracks in the bond market.
Below, once again, Jim Bianco, president of Bianco Research, joins CNBC's Rick Santelli to discuss Mario Draghi and the Fed normalizing rates.
And Rich Ross of Evercore ISI sees tough times ahead for the market while looking at a chart of the TLT. I would take all this technical stuff with a grain of salt, especially after a one day move!
Lastly, Richard Saperstein, HighTower Treasury Partners managing director, discusses why it’s time to be cautious following the latest Fed speak and ahead of the election.
I don't know, call me a skeptic but even though October is right around the corner, I still think it's time to plunge into stocks, just pick your spots very carefully. On that point, I agree with Bank of America CEO Brian Moynihan, US stocks will keep rising.
On that note, please remember to subscribe and/ or donate to this blog on the top right-hand side under my picture. Have a great weekend!
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