Over the last two days, bond markets across the globe have gone parabolic. Forgetting bond markets in Argentina, Austria and Germany, where investors are now prepared to loan these governments their money and pay them interest for doing so. Let's take a step back and consider just the U.S. bond market for now, as one can argue of the systemic risk in some of the other countries mentioned.
The U.S. yield curve has been a topic that has been beaten to death. Not a day goes by where a headline mentioning the yield curve or the shape of the yield curve is not observed in all of the major news sources. I am sure even the local cabbie is quoting the latest U.S. 10-year bond yield curve to his passengers.
Generally speaking, as the U.S. Treasury curve inverts, it is meant to signal some sort of recession to come. Historically, this could be seen as causal, but there is no firm evidence to suggest this to be the case. Academically speaking, one can understand the dynamics behind what that means and why it could lead to a slowdown. Timing it is another matter altogether.
On Thursday, the 30-year U.S. government bond fell below 2%, trading at 1.96%, which is the lowest it has been since 2007. Now the entire U.S. yield curve is inverted, an ominous sign in and of itself. Other various doomsday indicators like the 10-year/2-year U.S. Treasury spread has now moved into negative territory, aside from the 3-month/10-year yield spread.
Pick and choose any part of the curve you want and call it symbolic, the fact of the matter is that the U.S. bond market (and global bond markets) are signalling real duress or just too much money chasing it. They are broken and something has got to give with more than $15 trillion global debt trading with negative yields.
Credit markets tend to show signs of stress way before equities and other asset classes. One favored indicator, Libor/OIS spread -- which tracks the difference between the overnight Fed rate and the spread between interbank rates -- is currently trading at extreme wide levels, the widest since February 2018. More importantly, enough investors are so bulled up on the long bond trade that today hedge funds are most-long the front end of the yield curve, as despite rates being at record lows, they expect the rates to go even lower. Perhaps Wikipedia needs to redefine the word insanity.
So, what is causing this insanity?
As bonds go up, yields, gross or real, tend to go down. As the cycle matures and growth starts to slow, the market bids up the price of bonds as they expect the Fed to lower interest rates. It is a defensive trade. However, bonds are a natural part of any pension fund's portfolio given its duration and yield to maturity dynamics. There is always a "natural" demand for bonds at the long end by institutions and pension funds. However, at times of extreme fear and growth/cyclical slowdown and/or recession fears, bonds are aggressively added to portfolios as money is taken out of equities. This seems to be the case today, as money is blindly chasing bonds.
There is no debate this has been the longest expansion in history -- and the question on everyone's mind is whether this cycle about to end. The answer is not so simple, as the cycle would have taken its natural course of normalization in 2018 as the Fed was normalizing its balance sheet after a healthy economic cycle.
Then came President Trump, who decided to accelerate the entire process, causing havoc on markets by embarking on his precious Trade War, which is nothing other than a distraction for voters to make himself be seen as the winner: Theatrics at best.
As Trump has tried to squeeze China to give in to all U.S. demands by increasing the tariffs imposed, China has stood firm. They will negotiate and perhaps buy more goods, but they will not let any foreign policy dictate their domestic agenda. This eye-for-eye contest over the last year has caused an economic contraction globally, accelerating the slowdown. Central banks around the world are cutting rates and printing ever more money as they are scared. They never learned the first time around.
As fiat currencies are slowly moving towards extinction, the demand for gold has risen -- rightfully so -- but also alternative currencies like Bitcoin. Investors are worried about currency wars as central banks rush to debase their local currencies lower than the next neighbour. That has created even more demand for bonds, which are trying to tell the U.S. Fed that they need to cut rates now and aggressively. The Fed Funds rate is around 2.15%, too high given where the market thinks it should be. The Fed is torn between cutting now to prevent global PMIs from shrinking even more vs. a domestic U.S. labour market that is still growing at decent rates with unemployment at lows.
Bonds going higher can tend to have positive implications for equities in general, as yields are lower, raising the DCF value. But it is not the direction but the speed at which it moves that is of more significance. One doesn't need to look much further than pulling up the iShares 20+ Year Treasury Bond ETF (TLT) ticker. The market is truly worried that we are entering deflation at the rate bonds are being bid. Lower rates in this case tend to be negative for cyclical assets and equities.
On Friday, the U.S. released the Philadelphia Fed Survey and Empire Manufacturing data for August, showing better-than-expected results for both; an improvement. If the U.S. data is not that bad, shouldn't bonds be sold rather than bought at these euphoric levels?
It seems the long end is way too bid and a correction of sorts is due. Timing this is always hard, but the risk reward of being short U.S. bonds via the $TLT and long S&P 500 $ (SPY) for a trade makes sense at these levels. Even if the equity markets move sideways, the spread can narrow.
Short term equity market sentiment has been damaged severely, with the market falling 8% last week and trying to break 2850 two times but holding firm for now. Short volatility positioning has eroded, as the shorts ran for cover with $VIX trading at $23 now from the low teens. AAII Bull vs. Bear sentiment are all showing massive bearish extreme readings and sentiment is at lows. To call it a bottom would be overstating it, just a short-term bounce.
As always, investing is all about risk vs. reward. Perhaps that will be the trade of the year or decade, for the U.S. bond market to succumb to gravity and fall back down to reality.