The Bond Market's Ominous Warning?

Neil Irwin of the New York Times reports, If the message the bond market is sending is right, we should all be terrified:
The financial media tend to report breathlessly about what the stock market did yesterday. But savvy economic analysts have always known the bond market is the place to look for a real sense of where the economy is going, or at least where the smart money thinks it is going.

And right now, if the bond market is correctly predicting the economic path ahead, we should all be terrified.

But, please, read on before panicking. There’s a lot more to the story.

The stock market can rise and fall for all sorts of reasons, and sometimes for no apparent reason at all. But the bond market, where trillions of dollars change hands and long-term interest rates are determined, is steadier (normally). Its prices are generally tied closely to the outlook for growth and inflation over the years ahead.

The long-term interest rates that currently prevail across all the major advanced economies are consistent with a disastrous economic future. Taken at face value, they imply that the smart money expects inflation will remain extraordinarily low for years to come, and that growth will stay so weak that central banks won’t be able to raise rates for years. It is a shift that has accelerated since Britain’s vote on June 23 to leave the European Union, but one that has been underway for years.

Look at the current shape of the American “yield curve,” the chart of how rates compare for short, medium and long-term bonds. It implies a 60 percent chance of a recession in the next year based on historical patterns, according to Deutsche Bank analysts. Long-term interest rates hit record lows last week — which is to say the lowest in the 227-year history of rates in the United States.

Prices for inflation-protected bonds suggest that consumer prices will rise only about 1.4 per cent a year through 2021 —and only 1.5 per cent in the five years after that. They suggest that not only is the Federal Reserve unlikely to find conditions that warrant an interest-rate increase in the remainder of 2016, but also that there is only about a 50 per cent chance of a rate increase in 2017.

Across other major advanced economies, the signals sent by bond prices are even worse. Ten-year bonds are now offering negative interest rates in Germany, Japan, Switzerland, Denmark and, as of Friday’s close, the Netherlands. That means buyers of these securities will get back fewer euros, yen, Swiss francs or Danish kroner than they invested, a development without precedent in hundreds of years of financial history.

But that phrase “taken at face value” is doing some heavy lifting here. There are reasons to think that current prices are reflecting idiosyncrasies in the supply and demand for safe assets, rather than a conviction among global investors that very bad times are ahead.

Many of the purchasers of government bonds do so not because they find the returns offer compelling but because they have to. Insurers face regulators who may require that they do so. Pension funds seek to offset long-term obligations with safe assets of similar duration. Banks buy bonds to comply with rules limiting how much risk they can take.

In the last few years, central banks have become the biggest buyers of bonds. The Federal Reserve’s program of quantitative easing — buying bonds to try to stimulate the economy — ended in 2014, but the European Central Bank and the Bank of Japan are just getting going; the ECB is buying 80 billion euros’ worth of securities a month.

So you have a strong demand for bonds coming from institutions that are willing to buy at almost any cost — they are inelastic, in economic terms.

Then on the supply side, governments have not exactly been issuing vast supplies of new bonds, for reasons involving anti-deficit domestic politics. The value of outstanding German general government debt was $1.8 trillion at the end of 2015, for example, down from $2 trillion a year earlier.

Whatever you think of the wisdom of using government deficits to try to prop up a faltering economy, governments for the most part simply are not responding to very low interest rates and depressed economies by radically increasing deficit spending and thus increasing the supply of bonds.

So rising demand for bonds that is largely indifferent to price (even a willingness to buy the bonds at a certain loss) along with pretty much fixed supply combines to drive up prices, which in the bond market means driving down rates.

And even though the United States isn’t the prime driver of this — the Fed has ended its QE program, and American debt outstanding continues to rise — the bond market is sufficiently global that it’s an important part of the story.

When German and Japanese bonds are offering negative returns, the 2 per cent or so that U.S. Treasury bonds were offering earlier this year looked extremely attractive. Essentially the United States has imported this very low interest rate environment from overseas, even though the domestic economy is in pretty good shape and the Federal Reserve had been planning interest rate increases.

So even though in normal times bond prices give useful information about the likely path of inflation and growth, this might be an instance when those indicators are less useful.

Among the evidence that the recessionary signals out of the bond market are wrong? If bond prices are an unreliable yardstick, we can look to other markets that may be flawed, but are at least flawed in different ways.

And those other markets aren’t flashing recession warnings at all: The United States stock market closed Monday at a record high; indexes of future stock market volatility are quite low; and oil prices, after a furious rally since the winter, have mostly held onto their gains.

So how much of the drop in interest rates can we really pin on these supply-and-demand factors in the market for bonds, as opposed to a genuine shift in investors’ expectations about the future? Roberto Perli, an economist at Cornerstone Macro, has tried to disentangle the parts of the puzzle.

He estimates that about three-quarters of the drop in American Treasury yields since the start of the year is because of a decline in the “term premium,” or the compensation investors demand for tying up their money over many years. This is largely attributable to those supply-and-demand factors. He attributes about one-eighth of the drop to investors’ perception that the Fed will raise rates more slowly for any given economic circumstance than they had assumed at the start of the year.

He attributes only one-eighth of the drop to an actual belief among bond buyers that the economy will grow more slowly in the years ahead than they had thought at the start of 2016.

There’s good news in that as well as bad. The good news is that most of the drop in long-term interest rates is being driven by things that have little to do with the underlying strength of economic growth. The bad news is that some portion of the drop really is being driven by more pessimistic economic views, at a time a great deal of pessimism is already baked in.

The bond market right now is like a speedometer that is miscalibrated and therefore unreliable. It may be less useful than usual, and is not to be interpreted literally — but it’s still telling us something. And that something is that we should be worried about the possibility the world is in a nasty deflationary economic trap that won’t get better anytime soon.
The disconnect between the bond market and stock market has confused many investors, including yours truly. Right now, it looks like we're going to avoid a summer crash as stocks keep making record highs and some think we're in the early stages of a melt-up phase.

Even my former BCA Research colleague and former SAC Capital economist Gerard MacDonell is openly worried about another equity bubble developing.

I trade stocks and look at all sectors and what strikes me is the strength in some material and energy stocks I track to gauge the global recovery (click on image):

A lot of these stocks are way above their lows from earlier this year and many are making new 52-week highs and are being bought at every dip, suggesting momentum is clearly still with them.

Also, when I look at ETFs I track, I see momentum pretty much everywhere but it's obvious that gold miners (GDX) and junior miners (GDXJ) as well as silver (SLV) have helped propel the S&P Metal & Mining ETF (XME) to a new 52-week high (click on image).

There's even momentum in emerging markets (EEM) led by China (FXI) today which is one reason why oil (USO) is rallying and US bonds (TLT) are selling off as the yield on the 10-year note backs up to 1.53%, which is higher than the low of 1.36% reached earlier this week.

Still, there is a voracious appetite for US Treasuries led by Japanese investors which have been buying massive amounts as speculation mounts that the Bank of Japan is preparing to cut rates further into negative territory later this month or the government implements some form of soft helicopter money (both policies will weaken the yen; click on image to view Japanese US bond purchases):

Interestingly, the British pound was on track Thursday for its largest daily gain since the late-June Brexit vote after the Bank of England surprised investors by leaving interest rates on hold, saying it will wait for more data about the economic impact of the June 23 UK referendum on European Union membership before deciding whether to cut interest rates.

The huge drop in the British pound following the Brexit vote should have been enough of a signal that the Bank of England was in no hurry to cut rates further until it sees more data but the market was widely expecting more easing.

This brings me to an important point. Last Tuesday, I wrote a comment on the Summer Crash of 2016 where I wrote:
My own reading is that the Brexit vote was Europe's Minsky moment and if central banks didn't calm markets, it would have been much uglier last week. Still, no matter what central banks do, George Soros is absolutely right, Brexit will reinforce deflationary trends that were already prevalent.

And this is the key you all need to understand, deflation isn't dead, central banks can pump massive liquidity into the system but they can't resurrect global inflation. In fact, bond guru Jeffrey Gundlach thinks that central banks are causing more deflation by introducing negative rates. He says there is a bear market in confidence in policymakers and he's been long gold and gold miners in his macro fund all year.

He might be right,  there may indeed be a bear market in confidence in policymakers which is why silver just vaulted above $21 for the first time in two years and gold advanced for a fourth day on speculation of more central bank stimulus in the wake of the UK’s vote to leave the European Union. Mining shares also surged.

But if you ask me, the rally in gold (GLD), silver (SLV), oil (USO), metal and mining (XME), energy (XLE) and emerging markets (EEM) shares which registered 8.6% gain in the first-half this year, outperforming developed markets by 5.5%, the best first-half performance since 2009, is nothing more than a function of the weak US dollar (DXY). And because I see the US dollar gaining strength in the second half of the year, I would steer clear of all these sectors including gold and silver.

Instead, I continue to recommend good old US bonds (TLT) as the ultimate diversifier in case something goes awfully wrong. It's worth noting that even though global bonds are in the Twilight Zone, the yield on the 30-year US Treasury bond hit a record low on Friday amid global bond rally.

What is the bond market worried about? It's looking beyond Brexit, worried of the deflation tsunami I warned of at the beginning of the year and increasingly worried about another Asian financial crisis which will really reinforce deflation for another decade or decades to come (keep your eye on the surging yen, it could trigger another crisis).

In fact, bond markets have a message on the economy that stock investors might not want to hear. In this deflationary environment, it's very difficult to envision stocks melting up even if central banks  are lining up to do the wave following Brexit.

But what if Brexit doesn't reinforce deflationary headwinds and instead unleashes inflationary forces in the form of fiscal stimulus across the world?

I mention this because Caroline Miller, BCA's Chief Strategist and a former colleague of mine at the Caisse, put out a great blog comment, Will Brexit Put the Bond Bull Out to Pasture?. I highly suggest you read it carefully as she raises excellent points including this one below (click on image to read passage):

Caroline is one smart lady and she may be right, the political and economic uncertainty of Brexit could force politicians everywhere to finally increase fiscal stimulus to try to boost stagnating lower and middle class real incomes (again, read her entire comment here).

However, I remain highly skeptical that anything policymakers do now will be enough to resurrect global inflation. Readers of my blog know that rising inequality is just one of six structural themes as to 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. 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: 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 under crushing poverty. But 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.
  • 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.).
Why am I bringing this up? Because the stock market is acting as if reflationary policies will succeed while the bond market is preparing for a protracted deflationary episode.

And while some think negative yields outside the US are "distorting" the US bond market, I would be very careful here because the fact remains Asia and Europe remain mired in deflation which can easily spread to the United States via lower import prices. So maybe the bond market has it right.

In fact, I warned of deflation coming to America almost two years ago when people were warning of the bond bubble bursting. Well, the bond bubble hasn't burst and I doubt it will any time soon as my reading is ultra low rates and the new negative normal are here to stay.

Yeah but the stock market is on fire and cyclical shares are surging which suggests global growth is coming back and rates will start rising.

I would be very careful here. There are multi billion dollar quantitative CTA funds playing trends in stocks, bonds, commodities and currencies and they too are distorting these markets on the downside and upside.

All this to say, while I don't see an imminent crash this summer, I agree with Jeffrey Gundlach, chief executive officer of DoubleLine Capital, who said on Tuesday that there is "big money" to be made on the "short side" if equities fail to stay near current highs.

Where I disagree with Gundlach is when he talks up his macro book stating gold is the better alternative to Treasuries and equities. Negative yields or not, US bonds remain the ultimate diversifier in this deflationary environment (bond managers don't like negative sovereign yields but they better get used to them).

Tread carefully in these markets and  be ready for anything. I still like high beta biotechs (XBI and IBB) and have been adding to my positions on big dips but I'm ready to stomach insane volatility in order to make the big returns.

Right now, all markets are levitating up as central banks pump massive liquidity in the global financial system. Volatility (VXX) is getting crushed and there is a lot of complacency out there.

But as I finish this comment a bit late on Thursday, news broke out of another terrorist attack in France. The world is a dangerous place and I fear that terrorism is on the rise in Europe and elsewhere. I hate to say it but this too is very deflationary.

Below, Columbia Threadneedle EMEA CIO Mark Burgess discusses the hunt for yield in a negative world with Bloomberg "On the Move" hosts Anna Edwards in London and Caroline Hyde in Berlin.

Also, Rich Ross of Evercore ISI discusses why he sees bond prices heading higher, driving yields down even more.

Third, Katie Stockton, BTIG chief technical strategist, tracks the S&P 500 to see if the market is on the verge of a possible breakout. "I want to see consecutive Fridays, so two weekly closes in the S&P 500, above that 2,135 level. That would convince me that we've broken out," even with summer's traditional light trading volume, Stockton said on "Squawk Box."

Her sentiments were echoed by Stephen Suttmeier of Bank of America who also thinks a very rare signal could send stocks to 2400 (fourth clip below).

But not everyone is convinced the stock market is getting ready to surge higher. Carter Braxton Worth, Cornerstone Macro, goes to the charts to break down the recent rally in the S&P 500 and warns this could be a fake out, not breakout (fifth clip). Listen carefully to his comments on risk-adjusted returns between stocks and bonds.

Lastly, Larry Fink, BlackRock CEO, talks about what's driving stocks higher stating the market shouldn't be at record highs. "I don't think we have enough evidence to justify these levels in the equity market at this moment," Fink said Thursday on CNBC's "Squawk Box."

Fink also  stated this on US bonds: "I would not be surprised — I'm not predicting it — if somebody told me the 10-year Treasury is at 75 basis points, I would not be surprised."

All this to say while the stock market is setting new record highs, the bond market is unimpressed and is sending a clear message to be on guard because risk assets could get clobbered in the near future.

I can't tell you who is right because I too am playing the trends in some risk assets (mostly biotechs) but I'm nervously looking at the bond market which is telling me to temper my enthusiasm.

I'll be back next week, hope you enjoyed this comment and my apologies for the delay. It's the summer so I'm not blogging as much as usual, focusing more on trading and analyzing these volatile markets.

On that note, please remember to kindly support this blog via your PayPal contributions on the right-hand side under my picture. Thank you and have a great weekend.