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By Stewart Richardson on 21/05/17 | Category - Fixed Income
To view a PDF copy of this report, click here. 
 
Last week, we promised a more detailed explanation of our current market views. We want to concentrate this week on bonds, where frankly we believe price action makes more sense than in equity markets. To set the scene, we are positively disposed to US bonds especially compared to core European bonds which we continue to believe offer extremely poor value. With no new obvious source of growth and poor demographics, record high levels of debt almost everywhere and wide and/or worsening inequality in many Western countries, the world economy remains in the "muddle through" phase at best. In fact, considering the mature phase of the economic cycle, coupled with global monetary policy makers now tightening monetary policy, we believe that there are opportunities in some high quality fixed income areas. This all needs some further explanation, so let's dive in.

First, we show in chart 1 below the history of the US 2s10s yield curve, the components of this iteration of the yield curve and the Federal Funds target rate. If we start by looking at the Fed Funds rate (in blue), it is clear that as the Fed raises and reduces interest rates, the 2 year bond yield broadly follows. This makes sense. However, the Fed has less control over longer dated bonds which are affected by factors like inflation expectations, term premium as well as the expected path of short rates in the future.

As can be seen clearly in measuring the difference between the yields on the 2 and 10 year bond (the green line in the lower panel), there can be some large swings over time. Historically, zero or a bit below is the lower boundary and between 250bps and 300bps is the upper boundary. As we all know, the post Great Financial Crisis (GFC) recovery has been like no other in some respects, especially when looking at US monetary policy. With QE designed to takeover from interest rates in stimulating the economy, academics designed a shadow Fed Funds rate to measure this extra accommodation. We have noted with the white vertical lines the date that this so-called shadow Fed Funds Rate bottomed at nearly minus -3%. We can argue later whether the Fed's tightening cycle started at the low of the shadow rate in May 2014, or the first rate rise in December 2015, but what is obvious today is that the Fed is tightening policy, which is leading to a narrowing between the yields on 2 year and 10 year bonds; a flattening of the yield curve.
 
Chart 1 - US 2s10s curve with Fed Funds rate
 
The reason the above chart is so important is implied in chart 2 below, which shows the US 2s10s yield curve (in green) and US real GDP year on year (in red) with recessions shown by the shaded areas. We have advanced the yield curve by 12 months. There is no one single indicator that has a flawless track record in forecasting US recessions, but if we were marooned on a desert island and offered only one indicator, we would choose the yield curve. As can be seen, the last three recessions were preceded by the curve inverting (10 year yields trading at less than 2 year yields). 

For what it's worth, movements in the yield curve are not that bad an indicator of future changes in US growth, with the late 1990s period being an obvious exception when the flattening yield curve prevailed for some time as the economy performed strongly. We would suggest that this is the anomaly. In the late 1990s, the internet led to a mini (but ultimately temporary) surge in productivity. As noted above, we are struggling to see any new sources of growth in the next few years, other than a fiscal splurge that seems less likely today than it did the day after the US election last November.

Chart 2 - US 2s10s yield curve and real US GDP growth Y/Y %
 
So, without going into a deep dive on the current and prospective performance of the US economy, our simple road map is that the Fed is raising rates, and unlike last year, seems intent on doing so (and possibly reducing its balance sheet) almost regardless of the performance of the real economy - the Q1 miss is being dismissed as transitory by Fed members. As indicated by the Bank of America Merrill Lynch chart we show again below, once the Fed commences a tightening cycle, they continue until something breaks, either at home or abroad. We believe that the Fed will continue tightening policy until something breaks, and this will be apparent by a further flattening of the yield curve as the 2 year bond yield rises but the 10 year bond yield remains steady or even drops if recessionary signals increase. 

Chart 3 - The history of Fed tightening cycles ending badly
 
We detailed several times during late Q1 how we were happy to lean against the "reflation" narrative that was popular in the markets at the time. We were happy to express this view by owning US 10 year bonds via the futures market, and have remained long since near the lows in March. However, even if we are right that the yield curve flattens in the months ahead, this can occur with 10 year yields chopping around sideways or moving lower. We have enjoyed a nice little run in our fixed income positions and we have begun to take profits as we worry that price may be entering a short term consolidation phase - to be clear, we will be reducing our exposure as a tactical change due to market pricing and positioning only.

Chart 4 illustrates the 10 year Treasury Futures price alongside speculative positioning. What concerns us right now is that speculators have moved from being record net short in bonds to the longest net position since the GFC. To look at the situation at a more granular level, that shift in net positioning has occurred as long positions (green line in lower panel) have exploded higher. Yes, short positions remain quite elevated, and further covering of those positions could push prices higher, but with a near record long position now held, there has to be room for some long position liquidation if economic data improves. We are therefore taking some profits as we don't want to get caught on the wrong side of a temporary squeeze on long positions.

Chart 4 - US 10 Year Treasury and speculative positioning
 
Broadening out the discussion here, and as mentioned at the beginning, we continue to believe that core European bonds offer no value to investors today. Long-time readers will remember that we railed against the negative yielding bonds last Summer, and although longer dated bonds now offer a positive yield, shorter dated bonds do not. This can only last so long as the ECB is pursuing both QE and negative deposit rates, however, as explained last week, the European Central Bank appears to be moving away from these extreme policies.

With monthly asset purchases down from EUR80 billion to EUR60 billion, the ECB has only committed to maintain this pace until year end. Some in the market believe that the ECB will update their plans for next year at their June meeting, however, we suspect that they will wait until September. What is clear is that without a new crisis or plunging inflation, the ECB will be reducing QE further next year. We also suspect that they are keen to raise the deposit rate from the current minus -40bps back to zero as soon as practically possible. It is important to understand that even amongst central banking elites, there is no accepted wisdom that negative rates are either effective nor desirable over the longer term. And on this note, developments late Friday, with reports that Merkel wants Jens Weidmann to take over from Mario Draghi when he steps down in late 2019, may well add to the pressure for normalising rates next year.

So, assuming we are right that core European yields are only trading in negative territory today because of QE and negative rates delivered by the ECB, then are we right to assume that these bond yields will move into positive terrain as the ECB exits these extreme policies? We think so, and we think the process grinds on over the next 12 months and more. We also think an elegant way to attempt to profit from this trend is to short 5 year German bonds versus being long 5 year US Treasuries.

Chart 5 shows the relationship between the two. In particular, the green line in the lower panel measures the yield difference between US and German 5 year bond yields, and as can be seen the jump higher post the Trump victory pushed the difference to a historically very wide level. So the question here is simple. There appears to be an elastic band between these two that implies that the difference cannot remain above 200 basis points for that long. If so, what future outcomes will cause the difference to narrow or widen?

Chart 5 - US 5 year yield versus German 5 year yield
 
Perhaps the first point to make here is the obvious one. If nothing happens and yields simply remain the same, then our long US versus short Germany will pay us more than 2% per annum which is a nice carry trade in a near zero rate world. As noted, we are assuming that German yields cannot move much lower and even if the ECB ultimately has to do more, German yields cannot move much lower than the recent lows of minus 60 basis points. We therefore argue that the downside from the German leg of our trade is about 25 basis points. We would also assume that an event that caused the ECB to go all out again would be enough for the Fed to stop tightening policy, and perhaps even start cutting rates (let's not forget that several FOMC members keep telling us that they may have to do more QE during the next recession).

So the risk in our trade is that US yields rise more rapidly than German yields. And although this is perfectly possible, as we have noted, our belief is that the Fed will tighten policy until something breaks, which for the 5 year part of the curve means that any meaningful rise in yields due to Fed policy will likely be either ignored by the market as the yield curve flattens or quickly reversed as the Fed tackles the crisis that they create. In the meantime, if no reflation of deflation event transpires, we will collect our 2%+ carry.

Of course, there are no guarantees and certainly no free lunches in financial markets, but we do think that this trade can work in both a mildly "risk on" environment (as seen so far this year during which time the yield spread has narrowed from about 245bps to 215bps), and in a "risk off" environment as the Fed reverses course. The environment that hurts this trade is a unilateral reflationary environment in the US, which was clearly the initial market reaction when Trump was elected (and the spread jumped from 170bps to 260bps in short order). As we have explained several times since the Trump victory, we do not see the US reflation trade as a realistic outcome; certainly not to the degree that could cause the yield spread to gap by the same amount as last November/December. 

If Trump can get his growth policy agenda back on track, we suspect that the yield spread would widen but at a more modest pace. However, our original doubts of the ability of Trump to deliver a meaningful growth agenda have only been strengthened by his performance since he took office.

So again, recognising there are no free lunches, we really do like the look of the long US 5 year versus short German 5 year trade, as it pays a very nice carry for simply holding the trade. We have not been hurt by the trade during the equity market extension seen since February and we would expect a very positive return if markets shift to a risk off period which would no doubt lead the Fed to scale back on their monetary tightening process.

So to wrap up our bond market thinking, we are modestly long US 10 year bonds as we see the Fed on a tightening path until something breaks, which would no doubt then drive bond yields lower. We expect the yield curve to continue to flatten in the months ahead as well. On a relative value basis, we are long US 5 year bonds versus short 5 year German bonds. In fact, this is our single biggest trade in our multi asset macro fund.

Next week, we will go into detail about our equity market thoughts and current trade ideas. As we have detailed at length, the fundamental back drop is that long term equity returns are very likely to be poor because equity markets have risen so much since 2009 and valuations are expensive, especially so in the US. But valuations don't drive short term market performance; investor sentiment does. We have been waiting patiently for signs that sentiment towards US equities is about to change, and the current market setup is extremely interesting to us. 

As noted above, we have been taking some profits from our US bond holdings, and we have taken those profits (and a bit of extra capital) and invested that into bearish option strategies. We will examine these in more depth next week, but with a maximum pay out of 7.3:1 from these options, and our loss limited to the premium paid, we believe that our potential reward if we are right is very good compared to the capital we are risking. We even got a little excited when US equities sold off mid-week as Trump's troubles escalated, although the bounce into the weekend was obviously frustrating. We will go into more detail on this next week.

By Stewart Richardson on 06/06/15 | Category - Fixed Income
Bond markets endured another tantrum this week with the German 10 year yield touching 0.99% at one point, up from 0.05% in mid April and up 50 basis points from last week alone, before settling at around 0.84%. Other Sovereign bond markets were dragged lower by the move in German bonds with US bonds falling further after a strong headline employment report on Friday. The 10 year Treasury yield rose by 28 bps on the week to 2.4% with the yield up nearly 60 bps from the nearby low in April.

Estimates are that Sovereign bonds have dropped by US$625 billion in value in recent weeks. To put this move from April in some perspective, an investor who bought the benchmark 10 year German bond in mid April has now lost 7% of their capital in less than 2 months, or fourteen times the total return they will earn over 10 years. Not only are these moves beginning to add up to a serious re-pricing of very important benchmark markets, but investors are realising just how difficult it is to sell at what they think would be a reasonable price as liquidity has proved to be extremely poor during these tantrum periods. 

The heightened volatility in the bond markets spilled over into the FX markets. Initially, the rising yields in Germany were seen to be supportive of the Euro which rose by 4.5% against the Dollar from the low on Monday to the high on Thursday, and then falling nearly 2.5% into the close on Friday. There was even some spill over into the equity markets with European indices down nearly 2% for the week and the US down a bit less than 1%.

Although there may well be a benign outcome in markets which would obviously suit nearly all investors, there is a very bearish outcome that we have discussed before and wish to highlight again. The basic problem is that central bankers have pursued ultra-easy monetary policies that have caused bubbles in nearly all major assets and some minor and alternative ones as well. At the same time, regulators have changed the structure of markets which has caused liquidity to become much more scarce. This combination of extremely overvalued assets with poor liquidity becomes a major problem when enough investors want to cash in their chips and find there is simply not enough buyers at market prices. These conditions are likely to lead to "air pockets" in markets when price falls fast in a short period of time which may well encourage other market participants to hit the sell button, thereby creating a vicious cycle otherwise recently known as tantrums, or in less polite language, a crash.

We have stressed for some time how fundamentally overvalued markets have become, but predicting the turning point is nigh on impossible. Any investor who had been holding onto European Sovereign bonds assuming that ECB QE would keep prices high or higher now has to either sell at much lower prices or hang on and hope for a rally. Our point here is that waiting for a turn in market momentum before selling may well be a flawed strategy as poor liquidity causes price to drop faster than sell orders can be executed. 

Having seen a live example of such a bearish outcome unfold in German government bonds in the last 2 months (weren't German bonds supposed to be safe?), surely it is now not inconceivable that equities, which are overvalued on any reasonable valuation perspective, are at risk of some sort of tantrum or crash as well? It is our belief that such a scenario now holds a probability high enough that exit strategies have to be implemented now before the market turning point becomes obvious via sharply falling prices. 
 
 
We have indicated in the chart above of the S&P 500 that what we believe to be important near term support is actually very close to the current price, and so there is very little room for error here. We also believe that if these support levels begin to give way, price could fall a lot faster than most would like to think possible. For those investors that have already cashed in some or all of their chips, then no further action needs to be taken. For those that have not sold anything yet, we would counsel them to start implementing their exit strategies a bit more urgently. For those that want to make a modest bet that equities could fall in the near term, we believe that put options are relatively cheap and of course limit losses if the market moves against you.
 
In conclusion, our esteemed central bankers have pumped up asset values to fundamentally unsustainable levels, and our esteemed regulators have altered the market structure in a way that guarantees liquidity will be poor just when market participants want plentiful liquidity. This provides the set up for a very bearish outcome if enough investors/traders try and hit the sell button at the same time. Furthermore, it would appear that herd mentality is as usual leading to most market players following similar momentum based strategies which by definition will mean they look to exit at around the same time. We think the odds of a bearish market outcome developing in the next few months is far higher than many would care to admit.

By Stewart Richardson on 17/05/14 | Category - Fixed Income

Core G7 bond yields are trading at their lowest level this year. Nearly every strategist/commentator predicted that bond yields would rise this year leaving  the consensus surprised by this year's performance. We have to wonder whether bond markets are improving because everyone has been underweight and there has been a significant short squeeze in a market where liquidity can be an issue, especially for large investors. Alternatively, the current low yields pose a more fundamental question for economic growth assumptions.

As we have said in recent weeks, there is no doubt that the US economy will rebound in Q2 after a disastrous Q1. However, there are doubts about the Chinese, European and Japanese economies. At the same time, we know that central banks will either maintain zero rate policies for a long time (US and UK) or are even looking to increase stimulus (Europe and Japan). Low growth together with generous central banks should be supportive of the bond markets so are low yields a concern over future economic growth?

We can't help but look at Europe ex. Germany and remain concerned about the lack of growth. Despite plunging bond yields, a retreat on fiscal austerity and significantly positive swings in business and consumer sentiment, Q1 GDP was negative in Italy, Holland, Finland and Portugal and was flat in France. Spain was an obvious bright spot and Greece also managed to generate some growth, but generally across the EU there remains a lack of domestic growth drivers in what should be a relatively decent environment.

Despite the disappointing growth story in Europe, the biggest threat to global growth (and global capital markets) remains China. The official data is now showing a marked slowdown in new construction and home sales which will dampen economic growth. Land sales are also falling and this impacts local government revenues and therefore future growth. Most worrying, however, are actual declines in property prices which have been seen in all but tier 1 cities. With property widely used as collateral for many borrowers, any decline in collateral values in a highly leveraged system has the potential to be destabilising. Of course, many believe that authorities will simply do whatever it takes, and perhaps this will prevent systemic issues from arising in the short term. However, any stimulus to prevent short term pain will surely only delay an inevitable unraveling of a leveraged system that simply does not generate sufficient revenues to service the debt. In Hyman Minsky model terms, a large portion of debt is now of the ponzi type (i.e. requires ever higher asset prices for full repayment) and this is simply not sustainable in the long term.

And so back to whether bond yields are posing a fundamental question over economic growth assumptions. In the big picture, we think that global growth could very well disappoint and that G7 government bond yields will remain low. However, at 2.5% for US and UK 10 year bonds and 1.3% for German Bunds, the low growth environment we expect is beginning to be priced in. At some point, the shorts will have been squeezed enough and yields in the US and UK may rise a bit as US economic growth rebounds in Q2. As indicated in the chart above, in the short term we expect yields to find support in the short end at or just below current levels.

As for other assets, equities remain mostly range bound with major indices nudging the upper boundary and secondary indices like mid and small caps nudging the lower boundary. We have been at pains recently to explain our thesis that equities are adjusting to changes to the low growth/high liquidity equilibrium that was so bullish last year. Simply put, we continue to believe that equities are strenuously overvalued and the risk/reward ratio is poor in the short term and dreadful for long term investors. However, nobody cares about this until prices are heading lower, although we do get the feeling that both bulls and bears are becoming frustrated by the sideways action this year.

Overall, we get the sense that markets are extremely complacent at the moment and this can be seen in the chart below of equity and fixed income volatility. At some point, volatility will increase because low volatility is always followed at some point by high volatility (and vice-versa) and when volatility rises, bad things happen and investors get hurt.

By Stewart Richardson on 26/08/13 | Category - Fixed Income
With bond yields in the US and UK 125 basis points higher than they were less than four months ago (one of the most aggressive rises in yield on record over such a short period of time), is it time to buy bonds?

Before we answer our own question, perhaps we should try and understand why bond yields are rising. Is it because of faster growth expectations that will lead to a quicker removal of the current extraordinary policies? Is it a sign that the market is beginning to get worried about future inflation? Is it because investors are now demanding a greater term premium (for whatever reason) for holding longer dated securities? Or is it simply a reflection of investor psychology with investors dumping the underperforming asset and switching to the outperforming asset (in this case equities)? Most likely a combination of some or all of these factors.

We sit firmly in the camp that believes economic growth will remain relatively low for some time yet. We also sit in the camp that believes that inflation will remain subdued and that QE is not generating greater inflation because the FED's newly created reserves sit idle in the financial system (the only inflation being created here is asset price inflation -equities and housing). With weak growth and low inflation, nominal GDP growth will remain low by historical standards.

As can be seen from the chart below comparing nominal GDP and 10 year bond yields, the correlation is quite clear from a big picture perspective. With both nominal GDP growth and the 10 year both at 2.9%, perhaps the recent rise in bond yields (and slowing in the rate of economic growth) has brought the 10 year bond yield back to some sort of fair value.

During the 1960's and 1970's nominal GDP generally exceeded the 10 year yield - a period generally associated with rising inflation. The reverse was true in the 1980s and 1990s - a period generally associated with falling inflation. Since the turn of the century, there has been less of a clear signal. Perhaps, as a very, very rough rule of thumb, we can use nominal GDP as a guide to where longer term interest rates should be - I am sure that bond market purists will take some issue with this, but we are purely trying to illustrate that 3% may well be around fair value for bond yields if nominal growth is 3%.

A direct impact of higher bond yields (if sustained) is that debt will be more expensive to service and this will most likely be a headwind to growth. The chart below, courtesy of Bank of America, shows outstanding credit market debt relative to GDP. Clearly, debt has had to continue expanding at an ever faster rate than GDP just to keep GDP growing. If servicing this ever growing debt pile starts to increase (even from the current low level) then the greater amount of income is taken away from consumption and investment. We would also note (as seen in the next chart below) that yields have in fact risen since QE2, and so even if the FED wanted to contain long term yields, perhaps they are beginning to lose a bit of control now.

 

 

It seems to us that the FED policy of QE is increasingly being questioned, with even President Obama clearly stating that he does not wish to see policies leading to financial bubbles. If the FED is having to stop QE because the costs are beginning to outweigh the benefits and there is less support for it in both economic and political circles, then we have to try and understand what may happen when QE ends.

The chart below illustrates the FED's balance sheet and the 30 year mortgage rate. We have illustrated the start and end to balance sheet expansion (since QE2) with the green vertical lines and illustrated that the 30 year yield has risen during these periods (green arrows). In fact, as illustrated by the red arrow, the 30 year mortgage rates has risen since QE2 started. Conversely, when the FED has stopped expanding its balance sheet, yields fell.

Obviously, using only one example of the FED ending its balance sheet expansion to show that yields subsequently fall is hardly a robust sample size, but is all we have to work with. Perhaps what we should consider is that new rounds of QE have boosted the economy temporarily for a couple of quarters, and that when the stimulus is withdrawn, the economic boost diminishes and yields subsequently decline. We certainly have some sympathy with this view.

If the FED is now moving towards the exit because the costs of QE are beginning to outweigh the benefits, and nominal growth is already anaemic at 2.9% year on year, then perhaps the US economy will remain in the slow lane and a yield on the 10 year Treasury in the 3% area is around fair value.

Looking at the technical and sentiment indicators, the chart below of the 10 year note future shows a bullish divergence now in place and a bullish engulfing pattern from Friday's trading day. Similar patterns are apparent along the US curve. The sentiment indicators (not shown here) we use have generally shifted to a bearish extreme, which from a contrarian standpoint warns us that we need to be looking for buy signals, which is what we may well have got from Friday's bullish engulfing pattern.

 

As noted above, there has certainly been an asset allocation shift on the part of some investors away from bonds to equities. This group appears to be chasing momentum, and a turnaround in bonds (from bearish to bullish) and equities (from bullish to bearish) would most likely cause some investors to start selling equities and shifting back into bonds. Last week, we showed how the US and UK equity markets were testing support, which was subsequently broken in last week's trading. The chart below is an updated illustration of the S&P 500 which has broken support. Often times, after support has been broken a market will rally to test the underside of the support area. In this case, we can remain short term bearish so long as the S&P 500 remains below 1680 area.

 

In conclusion, we believe that the US economy remains stuck in the slow lane, and with the Fed having to move towards the exit, this will remain the case for the foreseeable future. We can make the case that a yield of 3% or so on the 10 year bond is around fair value and the recent rise in rates has brought us back to this zone of fair value. Bearish sentiment towards bonds has become quite extreme which is often associated with decent trading opportunities and it appears that the price action late last week is signalling that we should be adopting a bullish trading position here. Furthermore, if equities begin to struggle (after short term support was recently broken), then traders and investors may become more convinced that they switch some funds away from equities and perhaps back to bonds.

We may be a bit early in this call, but we are adopting a more constructive view towards US fixed income markets (and UK as well which are highly correlated with the US).

 

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RMG Wealth Management LLP is authorised and regulated by the Financial Conduct Authority (FCA). These reports are for general information purposes only and do not take into account the specific financial objectives, financial situation or particular needs of any particular person. It is not a personal recommendation and it should not be regarded as a solicitation or an offer to buy or sell any securities or instruments mentioned in it. This report is based upon public information that RMG considers reliable but RMG does not represent that the information contained herein is accurate or complete. The price and value of investments mentioned in this report and income arising from them may fluctuate. Past performance is not a guide to future performance and future returns are not guaranteed.