Thursday, November 1, 2018

The Bond Bull Bull?

Jeffrey Snider of Alhambra Investments wrote a comment earlier this week on the Bond Bull Bull:
On February 12, 1999, the Bank of Japan announced that it was going full zero. Japan’s central bank would from that day forward push the overnight uncollateralized lending (interbank) rate to the zero lower bound. Further, it pledged to keep it there until Japan’s economy recovered.

The economic slump in the nineties had been by 1999 almost a decade in length. As the Japanese economy ground to a halt, unmovable and completely resistant to being restarted by any of the orthodox techniques tried up to that point, there came to be an institutional bid for government paper. It was the perfect illustration of Milton Friedman’s interest rate fallacy – low interest rates signal tight money in the real economy. The bid was pure liquidity risk, having nothing to do with the “fundamentals” of bonds.

ZIRP was intended to try and change that condition. The mere rumors about it all the way back in 1998 had kicked off a BOND ROUT!!! From September 1998 through February 1999, it seemed as if the so-called bond bull market had finally been broken. Central bankers would ride to the economy’s rescue with non-standard “accommodation.” (click on image)


The bond market for a brief time operated in the same misconception as Japanese central bankers. We are taught from Economics 101 that central banks are central; that when confronted with stubborn economic circumstances they need only use the tools they have available.

In nineties Japan, then, what was missing was the will to deploy all of the various methods at the disposal of uninhibited central bankers. The world’s first zero interest rate policy seemed like a change in at least official mindset. The bull market would be history.

Except, there is no such thing as a bond bull. It just doesn’t happen, at least not that way. The term has been conjured by bond shorts as a way to make it seem there is no value, therefore no justification, for interest rates staying ridiculously low.

We can all agree on at least that idea; interest rates should never, ever be low for a prolonged period. But the bond bears are dead wrong about why they get there and more so why they stay there. Economic and liquidity risks are ultimately what this is all about. Bull or bear, those are fundamental terms inappropriate to the full range of government bond uses.

The bond “bull market” is simply the investors in that market, almost always the very banks themselves, expressing often deep skepticism over these ridiculous monetary schemes. This disbelief, however, is variable. There are times, like late ’98, early ’99 when markets might bet differently; that what might seem like a zero percent chance of success in late ’98 could be turned into a slightly positive chance by the actual implementation of ZIRP in early ’99.


Even as late as the middle of 2000, the “bond bull market” still seemed precarious. In August of that year, the Bank of Japan ended ZIRP based on its forecast of a recovering Japanese economy. Embarrassingly, just months afterward the central bank would be cutting back to ZIRP all over again; the first of many forecast errors on the part of monetary officials who always model their efforts favorably.


By the middle of 2003, though the nineties “bull” trendline had stayed steadfastly broken it didn’t matter in the slightest. Interest rates were lower by then than they had been at the lowest point during the prior decade. Like the term, these multi-year lines are ultimately arbitrary and not meaningful.

What matters is perception and ultimately correct views on where things are heading. It sometimes can take years for that to become fully apparent. The “bull market” was back in effect for a further three years until 2003, and then it was broken again for an additional four years beyond.


By July 2006, three years after BoJ had turned “hawkish” in June 2003, it would attempt a second “rate hike” regime. JGB’s had already smashed another even longer long-term trendline long before then; the 10-year yield in July 2006 was the highest since that spike into ZIRP in February 1999. Much was made of the highest yields in seven years. Showmanship, not honest analysis.


BoJ central bankers would actually get to a second rate hike in February 2007. They expected as did most economists it was just the beginning of policy, therefore interest rate, therefore economic normalization. With every “bull” trend broken, the central bank clearly hawkish, the Japanese market was set up for the mother-of-all-BOND ROUTs!!!!!!!!!!


It didn’t happen. Instead, as per usual, yet another forecast error. Central bankers were raising their policy rate and ending QE based on actually the same faulty premises. Japan’s economy hadn’t really changed.

It had gotten a bit better in the middle 2000’s, but it was increasingly clear to anyone outside the Bank of Japan’s offices that this wasn’t the same as actual economic growth and recovery. The Japanese economy had hit a sort of low ceiling that kept the actual upside very minimal, and therefore the same defects that had come to plague the system after 1989 were still present even more than a decade after the initial crash.


We know all-too-well how this story ends – or at least progresses up to the current day. Interest rates in Japan would go on to set new lows, negative yields almost all the way down the curve; even the 30-year bond would get almost to zero during the worst of the last “rising dollar” downturn in 2016.

There is no such thing as a bond bull market, which means that it can’t really end at least not on those terms. There is only the bond market deciding upon the right degree of skepticism as to whether the underlying economic condition, meaning money tightness, has meaningfully changed. A categorical shift in baseline direction.

Even if doesn’t, there can be times when market participants bet as if there is a chance it might. This is the usefulness of reviewing the JGB’s history. These periods of reflation can last years and break some new ground. But, in the end, the highest rate in years may not really mean what you think.

Variable degrees of skepticism just isn’t as shocking and spicy as shouting about the end of the bond bull market. What matters is not where interest rates are, it’s whether or not we are really out. Over time, that’s where prices and interest rates will develop. Given what’s going on now, I wouldn’t be at all surprised if over the next multi-year period UST rates not only register new lows less than 2016 but follow Japan’s under zero for a large part of the curve. It may take some time, there will be resistance from the short end with central banks the last to figure out what’s really happening.

Why?

Because nothing has changed. Eleven years of “accommodations”, ZIRP’s, and global QE’s and we are still staring at another downturn. The (non-linear) contraction remains in place – worldwide.
This is an excellent comment which casts serious doubts on the value of technical analysis and long-term trend lines when it comes to bond yields.

Snider's main point, namely, there's no such thing as a bond bull market, is a little more spotty even using the examples he provides.

Why? He's right that long-term trend lines are worthless when analyzing the bond market but there was definitely a big bull market going on in JGBs over two decades and legions of hedge funds shorting this market during that period and getting wiped in the process are a testament to the great JGB bond bull market.

Yes, there were periods of reflation, periods where economists swore inflation is coming back to the Japanese economy, and they were all dead wrong, just like economists claiming inflation is coming to the US economy and long bond rates are headed much, much higher will be proven wrong.

Earlier this year, we had the bond teddy bear market and more recently, the global bond rout but nothing has really changed to justify the move up in long bond yields.

Importantly, and I cannot emphasize this enough, the structural (not cyclical) headwinds still support deflation, not inflation and the risks are mounting that it will eventually hit the US economy.

What structural factors? Below, I list the seven structural factors that lead me to believe we are headed for a prolonged period of debt deflation:
  1. The global jobs crisis: High structural unemployment, especially youth unemployment, and less and less good paying jobs with benefits.
  2. Demographic time bomb: A rapidly aging population means a lot more older people with little savings spending less.
  3. The global pension crisis: As more and more people retire in poverty, they will spend less to stimulate economic activity. Moreover, the shift out of defined-benefit plans to defined-contribution plans is exacerbating pension poverty and is deflationary. Read more about this in my comments on the $400 trillion pension time bomb and the pension storm cometh. Any way you slice it, the global pension crisis is deflationary and bond friendly.
  4. Excessive private and public debt: Rising government and consumer debt levels are constraining public finances and consumer spending.
  5. Rising inequality: Hedge fund gurus cannot appreciate this because they live in an alternate universe, but widespread and rising inequality is deflationary as it constrains aggregate demand. The pension crisis will exacerbate inequality and keep a lid on inflationary pressures for a very long time.
  6. Globalization: Capital is free to move around the world in search of better opportunties but labor isn't. Offshoring manufacturing and service sector jobs to countries with lower wages increases corporate profits but exacerbates inequality.
  7. Technological shifts: Think about Amazon, Uber, Priceline, AI, robotics, and other technological shifts that lower prices and destroy more jobs than they create.
I keep referring to  these factors because they're not going away, they're getting worse and people who ignore these factors are in for a rude awakening when bond yields plunge to new secular lows.

Yes, that's all fine and dandy, but what about the short run? DoubleLine's CEO Jeffrey Gundlach, the new bond king, loves going on Twitter poking fun at bond bulls:



So, despite the October stock selloff, the 30-year Treasury yield hardly budged that month and this proves that massive inflation is coming into the system and fears of deflation are way overblown?

Bullocks! Total rubbish! On Twitter, I even called Gundlach out and asked him if the Fed keeps hiking rates and provokes a crisis in emerging markets, what then? He didn't bother replying but these guys making bond bear calls annoy me because when you push their scenarios to their logical limits, they stay mum.

This year, we had cyclical inflation pressures because the US dollar was weak last year and import prices rose. Going forward, the strength in the US dollar this year means inflation pressures will abate next year.

And if the Fed keeps raising rates and another emerging market crisis develops, it's all but guaranteed that long-term inflation expectations will plummet and along with US long bond yields.

[Note: The Fed controls the short end of the curve, inflation expectations determine the long end.]

This is why I view the recent weakness in US long bond prices (TLT) as a buying opportunity and still maintain they are the ultimate diversifier:


You won't become rich investing in US long bonds (unless you're leveraged 100 times and your timing is impeccable) but you won't sustain heavy losses from your equity portfolio which should be defensive going into next year.

Lastly, for all of you worried that a big bad bond bear market lies right around the corner, Eric Hickman, president of Kessler Investment Advisors, an advisory firm located in Denver, Colorado specializing in US Treasury bonds, wrote an interesting comment on how the US housing market is predicting a Treasury bull market:
In my previous article, I discussed how the U.S. Treasury yield curve foretells an imminent bull market in U.S. Treasury bonds. This article corroborates those findings from the perspective of the housing market.

Among leading indicators, the housing market predicts economic activity with the longest lead time. Housing market indicators peaked far before the last three recessions – before the yield curve inverted, the Fed finished raising rates, U.S. Treasury yields peaked, and even before the index of leading indicators (of which building permits is a part) peaked. Logically, because the housing market represents the full breadth of the economy and its health is negatively affected by higher interest rates, it has slowed well before other indicators. An article on this here.

Of the many housing indicators, four have the longest history and most reliable leading properties. In their charts below, notice that the business cycle peaks (orange circles) precede the peaks in the 30-year yield (red lines) which come before the recessions (gray bars). (click on each image)





With the October 24th new-home sales report, the September 2018 housing data has been released and cements that a housing market peak occurred late last year/early this year. Specifically, the tentative peaks occurred between seven and 11 months ago (gray boxes with question marks in charts above):
  • New home sales, November 2017
  • National Association of Home Builders (NAHB) sentiment index, December 2017
  • Housing starts, January 2018
  • Building permits, March 2018
There is no guarantee that these indicators won’t turn around and make new highs – a cycle peak is subjective until much later. But, with the indicators peaking contemporaneously, the nine-and-a-quarter-year age of the economic expansion and corroboration with the yield curve, it is likely housing is past its best cyclical level.

The lead time between prior housing-market peaks and various business-cycle events can be used to project timing in this upcoming hypothetical cycle four (see table below, click on image):


The timing suggested in this study matches the findings of my prior article to within three months. It suggests a 30-year yield peak this quarter, the Fed funds rate and two-year yield peaking next year and a recession in 2020. These results most certainly oversimplify the uncertain nature of markets, but business cycles have more similarities than are readily known. It is helpful to be aware of them.
This is an excellent comment except Mr. Hickman should have given proper attribution to Francois Trahan who has been doing this exact analysis for years.

Anyway, the point is this, housing data leads the business cycle by six to nine months and given the Fed is bent on raising rates at least one more time which will make it a total of nine rate hikes, it's unlikely that these indicators will miraculously turn around.

And by the way, don't get too excited about the recent pop in the S&P Homebuilders ETF (XHB), it's still in bear market territory and very weak (click on image):


You will see many countertrend rallies giving people hope the downtrend is changing but it's not and won't change as long as the Fed continues hiking rates.

Anyway, that's it for me on the bond bull bull, hope this comment gives you some food for thought on the bond market. I remain long US long bonds (TLT) despite the weakness this year and still believe it's the ultimate diversifier.

If you're still not convinced about US bonds, make sure you read Hoisington's Quarterly Review and Outlook for the second quarter here. Van Hoisington and Lacy Hunt wrote another great comment explaining why the structurally weak US economy does not support current interest rate levels.

Oh, by the way, my favorite tweet yesterday came courtesy of GreekFire23:



That's priceless!!

Below, Nassim Nicholas Taleb, scientific advisor at Universa Investments, discusses the factors causing global fragility, hidden liabilities in global markets, and what he sees as safe trades in the current market. He speaks with Bloomberg's Erik Schatzker on "Bloomberg Markets."

Taleb is his regular doom & gloom self here and while I agree with some of his comments, I don't agree with everything he says. Still, prepare for a global economic slowdown which will hit us hard this time next year, and hedge your portfolio with good old US long bonds. That's no bull!!!

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