It's 1994 Again: Why Albert Edwards Expects An Imminent “Bond Market Bloodbath”
Following the Trump presidential victory, two prominent macro strategists have undergone a significant change in their outlook: while David Rosenberg, who started off with a deflationary, and bearish outlook, then flipped to inflationary (and bullish), has recently once more “mean-reverted” and expects a further drop in yields as deflationary forces return, his SocGen peer, Albert Edwards – while still expecting a deflationary “ice age” in the longer-run (in case there is any confusion, he expressly states “make no mistake. Unlike most in the markets, I remain a secular bond bull and do not think this 35 year long bull bond market is over”) now expects an imminent “bond rout” in the coming weeks as the Fed’s rate hike cycle leads to an aggressive selloff in short- as well as long-term rates. The result will be another “central bank-inspired recession”, which will lead to the convergence of yields on the 10Y US Treasury with Japanese and European bonds below zero, as the global deflationary ice age enters the final round.
Edwards’ summary of his current state of mind, just as the Fed is about to make (yet another) historic mistake, is – as usual – rather picturesque:
Make no mistake. Unlike most in the markets, I remain a secular bond bull and do not think this 35 year long bull bond market is over. I believe the US Fed has created another massive credit bubble that will, when it bursts, lay the global economy very low indeed. Combine this with the problems of a Chinese economy dependent on increasingly ineffective injections of credit to produce increasingly pedestrian GDP growth and you have a right global mess. The 2007/8 Global Financial Crisis will look like a soft-landing when the Fed blows this sucker sky high. The seeds for that debacle have already been sown with the Fed having presided over one of the biggest corporate credit bubbles in US history. All that is needed now is for the Fed to sprinkle life-giving rate hikes onto these, as yet dormant, seeds of destruction. Accelerated Fed rate hikes will cause tremors in the Treasury bond markets, forcing rates up, most especially in the 2 year – just like 1994. But as yet another central bank-inspired global recession unfolds, I believe US 10y bond yields will ultimately converge with Japanese and European yields well below zero – in other words, buy 10y bonds on weakness!
And speaking of 1994, and the reason why Edwards is confident that despite the market “pricing in” the Fed’s upcoming rate hikes, nobody has any clue what is about to be unleashed, the SocGen strategist reminds his clients of the Orange County “havoc” unleashed with the 1994 rate hike cycles.
For those few of us in the markets of a certain age, Orange County conjures up only one thing: 1994 goes down in infamy as one of the biggest ever bond market bloodbaths in history culminating at the end of the year with Orange County in California going bankrupt (younger clients in their late 20s will only know the OC as the mid-2000s teen programme based in Newport Beach, which I watched religiously with my then teenage son and daughter).
I remember the 1994 period as if it were yesterday (unlike yesterday itself). Despite the Fed telegraphing the series of rate hikes and market participants forecasting multiple hikes, it was most curious how the market went into total convulsion. I was chatting to my ?similarly young? colleague Kit Juckes about this and he reminded me that the whole yield curve gapped up some 50bp immediately! It was a bloodbath, especially for 2y paper.
For the benefit of readers who may have missed this particular episode in bond market history, Edwards here are some more details of how the 1993/1995 rate hike cycle flowed through to the bond market, and then promptly resulted in an inverted curve.
You really had to be there at the end of 1993 to understand just how widely expected the 4 February 25bp Fed rate hike was. I was at Kleinwort Benson back then and I remember articulating that rates could rise somewhat more than the market expected on our December 1993 macro European tour. There was no real pushback. I have managed to lose my Global Strategy Weekly files from that time to see exactly what I was saying then, but I have my yellowing press cuttings file! From the FT on 8 Feb 1994 I find this, “on Thursday (the day before the Fed’s first hike), Mr Albert Edwards of Kleinwort Benson wrote: In the US, Alan Greenspan could not have been clearer. He regards 3% as an excessively low rate which has served its purpose to eliminate the banking crisis and alleviate the credit crunch. The Fed does not care what headline inflation is, rates are heading higher. The risk is that the markets do not view a ¼% rate increase in isolation but the first in a series of tightenings, which it will be”. I was not alone in that view. It was quite common on the sell-side. What though we could not anticipate was quite how savage the bond sell-off would be.
Additionally, Edwards also shares two articles from that year, first from Fortune entitled “The Great Bond Massacre of 1994” see link, and also from December, when The New York Times analysed events surrounding the most high profile casualty of that year, namely Orange County, link. In a word the problem was leverage.
Fortune Magazine wrote in 1994, “Just as in the U.S., European bond investors were operating on lots of leverage. That made them just as vulnerable when the margin calls started to come. The result: “You had a snowballing liquidation completely out of proportion to the (economic) fundamentals,” says Gilbert de Botton, chairman of Global Asset Management in London. “Both the U.S. and Europe had been overexploited by investors on margin.”
“Back in New York, the report of extremely strong 6.3% real growth in the fourth quarter of last year, combined with Greenspan’s well-publicized fears about incipient inflation, struck new fear into bondholders. The Clinton Administration didn’t help matters. “The saber rattling over Japanese trade hurt a lot,” says de Botton. “(U.S. Trade Representative) Mickey Kantor’s allusions to the effect that the U.S. was not in favor of a strong dollar was an indirect source of forced selling (of U.S. bonds) by European investors.” Fearing currency losses and declining bond values, foreign holders of U.S. bonds began to pull out.
“Given all the leverage in the market, it shouldn’t have been surprising that long rates moved up sharply when the Fed finally began boosting short-term rates. Indeed, some members of the Open Market Committee voiced fears at the February 4 meeting that even a small increase in the Federal Funds rate could rattle the bond market. Rattle it did. The initial rise in long rates brought forth a flood of margin calls. Rather than put up more money, which many of them didn’t have anyway, speculators liquidated their holdings. With individuals bailing out of bond mutual funds as well, and little or no new money coming into the market, bond prices had nowhere to go but down.”
Edwards’ rhetorical question, here: “Does that snippet not sound eerily reminiscent of current events?“
He also points out that while the Fed has so far hiked rates twice in the current tightening cycle, “these have become such isolated hikes that the market (Fed Fund futures strip) has lost confidence that the Fed will ever deliver their promises as represented by the Fed dots.” With next week’s rate hike, however, all this will change.
There is another key similarity between 2017 and 1994:
The top chart shows that back in 1994, just before the Feb 4 rate hike, 2y yields were trading some 100bp above Fed funds. That one 25bp rate hike prompted the 2y-Fed Funds spread to soar from 100bp to 250bp within the space of three months while the 10y-2y curve flattened rapidly, destroying carry-trade bets along the curve. The key similarity with 1994 is that currently US 2y yields at 1.35% still trade tightly to the current Fed Funds rate of 0.75% (see left-hand chart below). If the market really takes on board Janet Yellen?s much more aggressive rhetoric, then we could easily see 2y yields rise towards the 10y as we did in 1994. If that happens and the US 2y spread with German and Japan continues to soar (see righthand chart below), this will be like rocket fuel strengthening the US dollar
Finally, while Edwards is hardly a technician, he provides two charts to substantiate his claim that a historic bond rout may be imminent: while the right-hand chart shows that US yields have now broken out and are heading to 2.65% and then 2.85% in the short term, it is the left-hand chart that is most interesting, “showing that US 10y yields can rise all the way to 3¼% and beyond and the secular Ice Age bull market in government bonds would still be intact.”
Edward’s conculsion: “In 1994, it was excess leverage that broke the market, culminating in December 1994?s bankruptcy of Orange Country and also the Mexican Peso crisis in that same month (due to dollar strength). I?m going to look harder for my 1994 Global Strategy Weekly file, for despite remaining a secular bond bull, I think we are in for a rough ride – especially with equity markets at record highs.”