After 10 years of manipulating the bond market, the Federal
Reserve has overstayed its monetary policy welcome and created systemic
conditions that will have high costs for everyone. There is a place for depressionary and
recessionary monetary policies, but that was almost a decade ago. With GDP approaching 3% and inflation running
above 2%, do we really need policies and statements that keep unwitting
investors in a perpetual state of fear reflected in bond market yields that are
usually reserved for severe recessions and depressions?
There is no question that this hyperactive Fed knows how to
throw every monetary policy tool at economic problems stemming from a dysfunctional
government that creates poor polarized policies. Yes, the Fed feels compelled
to correct these politically driven negative impacts and in the process
subsidize and fund them.
Political and egotistical reasons have limited the Fed’s
reversal of such policies. The Fed knows
the catastrophic financial impact of reversing a decade of market manipulation
in the bond market. Bond yields are
lower and prices higher than the overpriced conditions of 2006-2007 that lead
to the 2008 bond market crisis. If
conditions are worse now than then, need I say more on market embedded risk due
to mispricing? But the Fed knew the
conditions in 2006 and 2007 as well. That
is why they went on a 25bp rate rise campaign on their last tightening cycle. They feared excessive volatility would lead to
a quick repricing in the bond market and the uncertain economic and market
reactions.
Wash, rinse and repeat. The Fed has followed the exact play book – and
yes, you should expect the same results. However, investors do not have to come along
for the same ride. They can open their
eyes and acknowledge what is going on. A
decade seems like a long time ago. The
Fed is hoping short memories and the annihilation of any trader that focuses on
value in the bond market can assist in the slow unwind of this mispricing. But just like the 2006-2007 period, the slow
unwind didn’t lead to an unwind of the mispricing. Instead, it led to the addition of risk to
make up for lower net income and higher funding costs.
Today’s bond market reflects an eerily similar environment. As short term rates are adjusted higher on a
slow, highly expected path, traders and significantly invested participants are
squeezing the market through various techniques and bond prices are not
adjusting lower. With the Fed trying to keep
volatility out of the bond market, it creates an environment for oligopolistic bond
investors to limit losses through various manipulative and market squeezing
strategies.
Higher short term rates leave limited to no yield differential
to compensate for the risks embedded in longer term bonds. Some argue as the Fed raises rates, longer
term bonds should outperform due to a restrictive Fed. Wrong!
If the Fed was to have a restrictive policy, then yes, long term bonds
should outperform and be priced for a restrictive policy. But first and foremost, Fed policy will not be
restrictive until they unwind their balance sheet of over 4 trillion. Every trillion they own can be estimated up to
1% of easing. So rates should be 4% just
to have a neutral impact on monetary policy. Ignoring this minor impact, Fed
policy is not considered restrictive until the Fed Funds rate is 1% to 2% above
the level of inflation – currently running around 2.5%. So if Fed Funds were 4% to 6%, and longer term
bond yields 1% to 2% higher for an adequate risk premium, yes, you could argue
the bond market should be flattening – or longer term bonds outperforming.
Unfortunately, longer term bonds yield 2% to 2.5%. This is why the current mispricing is so potentially
devastating. Not only is the Fed raising
rates, but they are going to shrink its balance sheet as government bond
issuance is expected to surge. The Fed
has manipulated long term rates lower by focusing on longer term bonds and
removing duration from the market place. The government as well is looking at issuing
long term bonds, or add duration to the market place. The point is just like 2006-2007, the risks
continue to build in the market place, but prices and yields have not adjusted.
The crisis of 2008 would not have been a
crisis if yields reflected reality and were high enough to justify the risk
embedded in the market place. The same
is true today. Too much risk embedded in
a market place with not even close to enough yield to offset it. With a nod and a wink, the Fed helped manipulate
rates by saying they will keep rates lower for longer. The large investors took this and ran. Some of these investors now have hundreds of
billions stuck at low yields in the bond market. They can’t ever get out of these positions
without hurting themselves through much higher yields. Instead, they bide time manipulating rates
when they can, hoping for headlines or the next recession to contain the
eventual pain or a repricing.
And the manipulation is glaring. Going into the July Treasury auctions, it was apparent
there is limited appetite for purchasing bonds at these prices. Yields have been rising as auctions get
closer. The last auction, the long bond
rose to 3.05% yield to attract enough buyers. But once the supply is out, those that had to
buy it use high volume trading tactics during low volume periods to pop the
prices of bonds back up. Within days,
these traders were able to reprice a 3.05% yielding auction down to 2.86%. Make sense? No. But
this is where risk comes from. Those
that have mammoth bond positions that are cemented in will pursue whatever
strategy necessary, squeezing out those with opposing views to maintain current
yield levels. How did that work for the
Hunt brothers in the oil market?
Nothing holds a mispriced market together better than a diminishment
of volatility. Higher volatility makes
it visibly clear to all that there is too much risk for not enough yield. There is an asymmetric skew in current
economic data (topic of the next article) where growth, jobs and inflation are
all at the higher end of the range, yet bonds are still priced as if in a
recession or worse. Current employment based statistics and antidotal
information forecasts the payroll report should have been a monster number. Sure, the BLS has a knack to diminish volatility
in this number by coming out with one number then months later having
significant revisions. They justify this
by taking a symmetric approach to their volatility diminishing adjustments. At 138k, this number shows a healthy economy
and jobs market before revisions. However, I believe the strength of the jobs
market make this number likely to be eye popping upon revisions. As bond market prices reflect a recession, the
unemployment rate just dropped down to a seldom seen and envied 4.3%!!!
As a few very large balance sheets continue to trade and
support the bond market focused on minutiae such as the latest Trump tweet or
other tertiary information, don’t forget the variables in front of us all. The
economic environment is healthy and normal with a chance of running too hot,
the bond market is still priced for a recession and they Fed is slowly taking
the punch bowl away from the greatest party of all time.
by Michael Carino, 6/2/17
Michael Carino is the CEO of Greenwich Endeavors, a
financial service firm, 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. Do you?
via http://ift.tt/2slMkmv Greenwich Endeavors