The Federal Reserve has manipulated bond prices for the last
10 years. Yields in the US and abroad
are lower now than during the Great Depression – a period in time that could
justify such low yields. For those with
short memories, bond markets are more expensive than before and right after the
financial crisis of 2008. Longer dated
yields are at least 300 basis points richer than typical when inflation is
running around 2% as it is today. Yes,
the bond market in the US and globally are the most overpriced ever. We are now on the precipice of the catalyst
for the greatest bond market trade unwind ever – the end of the Fed’s quantitative
easing program.
I have heard all the arguments for why yields are so
low. Inflation is low, growth is slow,
the Fed is raising rates or lowering rates, buying bonds or selling bonds and a
plethora of the sky is falling fodder is credited for reasons to buy or hold
onto current positions in the bond market.
You can backfill this story any way you like. The truth is that the bond market has been
manipulated by the Federal Reserve lowering the Fed Funds rates to zero, buying
5 trillion of bonds and giving forward guidance that it is safe to come along
on the Fed induced bond buying binge.
The Fed’s commitment that they would not take the punch bowl away from
the party had definitely contributed to the bond buying bonanza.
Party Over! The Fed
has been warning the markets that the party has come to an end, Fed Funds will
keep going higher and their portfolio will be rolling off and reduced. Even though it’s last call, many participants
are lining up to load up on drinks, hoping the lights to the bar stay on a
little longer. Long term bond yields
have been manipulated by some of the largest bond trading firms during low
volume periods pushing yields back down to lows seen only during depressions or
catastrophes. These market distorting
strategies are masked by the Fed’s market distorting strategies. Even though short term rates are pinned near
the Fed Funds rate, long term rates have been manipulated to where the yield
curve is rather flat. You pick up very
little yield to compensate for the embedded duration risk, or price risk from
rising interest rates as you look out the interest rate curve.
As the Fed continues to raise rates and now unwinds their
massive bond purchases, the historically low bond yields leave the market is in
a tenuous position. Any day, and for any
reason, the bond market can experience parabolic moves higher in yield. As volatility increases, more bond managers
will evacuate the market place that has limited yield to compensate for the
volatility risk. Cash is now a viable
alternative and there is only a minimal yield give up with none of the risks in
longer dated bonds.
To be honestly blunt, investors are taking massive amounts
of risk in the bond market – consciously or unconsciously. Yes, some of the biggest risks with little
compensation. We have learned nothing
since the 2008 bond market meltdown. And
now we are at lower yields and higher prices since then. Worse, the bond market has almost doubled in
the last 10 years. I have to repeat
myself again. Doubled in the last 10
years!!! Lower yields in a market that
is twice as large and we still think this is going to end well?
The Fed has fostered and encouraged the current bond market
situation. They know their departure
from the market will be disruptive and have been trying to set the market up
for this for some time. Instead of
positioning accordingly, large participants have been high volume trading the
markets at the detriment to those that have tried to prepare for this next
chapter. This leaves the market poorly
positioned for the Fed’s withdrawal of market support.
The bond market has changed greatly from that of a decade
ago and there are a few large balance sheets that hold significantly large
positions. This distribution in the bond
market makes it impossible for the largest holders to ever sell their
positions. Any attempt to sell (to who?)
and yields would shoot higher. The best
they can do is to keep providing liquidity, supporting markets at these most
expensive levels and hope some event comes along to bluff the market into
holding these levels until they retire or sell their firms.
So what should the markets expect? I was vocally warning anyone who would listen
in 2006 and 2007 that the risks built in the system would be catastrophic when
they unwound. I continue to ring the
alarms now. After 10 years of driving
and pinning yields to ultimate lows and the fundamentals significantly divergent
from the market, market participants are unprepared for the end of the Fed’s QE
program.
With the end of QE and the largest buyer of Treasuries non-existent,
volatility will increase. Yields cannot
be justified when volatility increases and selling in the bond market will
begin. Money will move to cash and
redemptions submitted to bond funds and other fixed income hedge funds. But yields will move higher before the bond
fund redemptions are paid leaving larger losses and more panicked investors. Higher bond yields will not be met with the
buy the dips attitude. Rather, selling
will beget selling, liquidity will disappear and yields will start to gap
higher. Funds that knew nothing except
inflows will, unfortunately, need to limit redemptions and gate their
investors. As volatility increases and
liquidity decreases, the markets will crescendo into a financial debacle that
will only end when a large or a couple of large and popular funds that have
outperformed over the past 10 years have to close down. This will alleviate selling, but more
importantly, reprice the bond markets to a yield level that compensates for
risks and starts to attract sound investors.
This may seem like a dire prediction but it’s not. This is part of any normal market process
where prices go up and down. The
unfortunate result of 10 years of Fed market manipulation is that many bond
market managers are clueless as to how normal markets operate. Some traders were 10 years old during the last
bond market debacle! What worked for the
last 10 years will not work for the next 10.
As the Fed turns off the lights and locks up the bar, don’t find yourself
stuck inside looking for a way out.
by Michael Carino, Greenwich Endeavors, 9/19/17
Michael Carino is the CEO of Greenwich Endeavors and has
been a fund manager and owner for more than 20 years. He has positions that benefit from a
normalized bond market and higher yields.
via http://ift.tt/2hgLuCE Greenwich Endeavors