By Kevin Muir
Don’t you love it how, now – after the biggest sell-off in fixed income in decades – suddenly everyone is bearish?
Long-time readers will know how I am a Kodiak Brown when it comes to fixed-income, but even I can’t bring myself to sell into this hole. I mean, c’mon – do you really think that waiting for your guru to announce on CNBC that two closes above 3.25% for the 30-year bond constitutes a trading strategy?
The always insightful Trevor Noren from 13D Global Research recently tweeted a chart from the WSJ’s Daily Shot that demonstrated the true extent of the bond market’s oversold nature:
Whereas a quarter or two ago all the deflationistas were busy predicting the end of the world for risk assets, today they have switched to equally dire predictions regarding the bond market. Now instead of the warnings about the economy rolling over, they are banging the drum that the United States government will be unable to fund itself, thus suggesting bonds are a screaming sell.
Well let me you in on a little secret. The US will have no trouble funding itself. That’s not what’s going on.
If the bond market was truly worried about US government’s deficits, they would be monkey-hammering the long-end of the bond market. Yet the US 2-year note yields 2.88% while the 30-year bond is only 55 basis points higher at 3.43%. That’s not a yield curve worried about US fiscal situation.
And let’s face it, if Japan can maintain control of their bond market with their bat-shit-crazy debt-to-GDP level of 236%, the US will be just fine for quite some time.
Remember the narrative spun last month by the bond bulls about how the “largest bond short speculative position in history” would meet its fiery end when the US economy rolled over? I pushed back hard on this thesis. To me it felt like the theory was badly flawed and, if anything, the specs were leaning long (The “Big Bond Short” Illusion).
Now that bond futures have given up seven big figures over the course of the past few weeks, these same traders are telling us that fixed-income is headed much lower due to the “technical damage”. Gee thanks.
I sure wish trading was that easy. If I have learned anything from trading bonds over the past few decades, it’s that they rarely follow script. Yeah maybe currencies behave “properly” on a technical basis, but bonds are another animal.
This is a difficult post for me to write because long-term, I am extremely bearish on fixed income. I believe we have entered into a global bond bear market that will last decades. Yet within any secular bear market there will be rallies. There will be time to lean hard on the sell button, and there will be times to patiently wait. This is one of the latter times.
How to explain the recent action
So what’s going on? Why has the bond market sold off so hard?
Although many of those former-bond-optimists are confused by the recent price action, I don’t feel like it is such a mystery.
Let’s start with the first and most obvious explanation. Many of these bond bulls had extended out the curve as they were certain the economy was about roll over. Why were they so certain? Lots of reasons. The length of the economic expansion. The speed at which the Federal Reserve was raising rates versus the rest of the world. But most of all – the yield curve was sending signals the economy was weakening. I think there was a bit of Soros’ reflexivity at work. Bond bulls bought long-dated fixed-income because of the flattening curve which then sent a signal about a slowing economy, which then encouraged them to buy more, and so on. The market convinced itself that the economy was weaker than it was.
To some extent, this recent sell off is merely an acceptance the economic expansion is not about to collapse tomorrow. Think about it as the economic bears throwing in the towel.
But I would like to remind you of another post I wrote last month – “The End of the Incessant U.S. Bid?” Remember that September 15th was the last day for U.S. corporations to deduct pension contributions at the 2017 corporate tax rate of 35 percent? I argued this had caused an inflow into American pension funds which caused U.S. long-dated fixed-income to be bid.
Could it be that the bull bonds were misreading the signals the yield curve was sending? I sure think that’s a real possibility.
Bonds move for two reasons
The recent move in bonds has scared a lot of market pundits about a potential lack of demand in the bond market. These commentators seem obsessed with the demand side of the equation. And although the demand side is important, too many overlook the supply side.
Whereas most pundits view increasing bond supply as an ominous affair, they are taking too simplistic a view of things.
What is the global economy suffering from? A rising U.S. dollar as rates are squeezed higher by the Federal Reserve. But what we really need is more supply of US dollars.
Yet what happens when corporations issue billions of dollars of new credit? The supply of U.S. dollars is increased.
So whereas many are freaking out about mega bond deals like Comcast’s 27 billion dollar issue last week, I take a more optimistic view. Sure that supply causes bonds to sell off and for the curve to steepen. But that’s happening for the right reasons. We want corporations borrowing and expanding the money supply.
(Now you might make the argument that more debt doesn’t fix the problem of too much debt, and rest assured, I know how that tale goes. But remember to focus on what is, instead of what should be.)
Regardless of the economic doctrine you worship, it’s hard to argue with the effects of increasing credit. All else being equal, it should result in an increase in nominal growth and a lower relative currency level.
Therefore if bonds are declining for the “right” reason (ie: an increase in corporate supply), then we should see the U.S. dollar decrease and the yield curve steepen.
Wouldn’t that be a kick in the pants for all the deflation disciples?
But what are the chances of that happening? Over the past quarter or two, we have definitely experienced an increase in M&A activity in the corporate sector, but so far, true CAPEX growth has been elusive. Most of the corporate bond issuance has been a feat of financial engineering to fund stock buy backs.
And in fact, going into this summer, 2018’s corporate debt issuance was running below the level for the past three years.
Back to the recent Comcast deal. I expect to see more of those types of issuances, and ultimately, it will hopefully be liquidity friendly. You might hate it, but the global economy needs an ever expanding amount of credit to grow.
As that credit expansion occurs, it will be US dollar and yield curve negative. Don’t fall for the narrative that rising rates is U.S. dollar positive. That only occurs when rates are increasing because of a lack of demand (credit crunch), not when rates are increasing because of an increase in supply.
Thanks for reading,
East West Investment Management
Global Select Opportunities Fund
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