The Rats Are Fleeing The Sinking Bond Ships
Glen Hubbard, George Bush Jr.’s economic adviser, was a candidate
to replace Alan Greenspan as Federal Reserve Chairman. George Bush Jr. asked him if the economy
sputtered, what would he do. As he
described the typical monetary policy tool of adjusting the overnight Federal
Funds Rate, he said the net result would be to boost GDP by a half of a percent
to percent. I assume the same question
was asked to Ben Bernanke. Helicopter
Ben didn’t disappoint and won the appointment. As Chairman of the Federal Reserve, he got his
chance and threw everything including the kitchen sink at stimulating the
economy. He lowered the Federal Funds
rate down to zero and purchased trillions of bonds to expand the monetary base.
He unleashed the most excessively
accommodative monetary policy in history which was continued by current Federal
Reserve Chairman Janet Yellen. Fast
forward to today and we are on the cusp of a 3+% GDP, core inflation running
above 2% and full employment. However,
there are some perilous costs associated with such accommodative monetary
policy. The cost that should be the most
worrying is the unwinding of the ultra-low bond yields in the US and globally
that has just begun.
Bond yields and market volatility are on the rise. This is
the result of more normalized growth and inflation levels, less perceived
global risks and hope for continued growth in the future. Fixed income investors
have just begun to adjust to the idea of more normal yields in the bond market. It may seem tempting to dip a toe into the
bond market waters with this back-up in yields. But these are dangerous waters.
Don’t lose a toe. After 10 years of bond
markets rallying the unwind is just beginning.
Normalized markets for longer dated government bonds places
yields around 2% to 3% above the rate of inflation. And with inflation running at 2% and moving
higher, longer term bond yields should be greater than 5%, not the current 3%. If bonds yields backed up to the longer term
averages, market losses could be 40% or more for the longest maturity bonds.
The trillions in bond purchases that drove yields to
all-time lows have abated and that’s bad news for bonds. Banks have finished adding regulatory bond
purchases and central banks have ended or are close to ending bond purchases
for monetary policy purposes. Government
bond purchases made to limit rising currencies have now turned into sales to
limit currency weakness. And oil
producing nations are no longer looking to put their surplus dollars from oil
sales to work in the bond market. They
are now selling bonds to fund the holes in their fiscal budgets stemming from
low oil prices.
The last big purchaser of bonds still remains some very
large and leveraged hedge funds. Hedge
funds have been caught on the wrong side of the global bond trade and are now
trying to avoid selling their positions. Fear and greed had helped keep bond yields at
these low levels for longer than most would have thought. In fact, yields have been so low for so long,
anyone betting on higher yields has been fired, put out of business, or
probably has a laundry list of stress related health problems.
Whatever backup in yields we’ve seen, it’s just the first
movement it what is sure to be an unharmonious symphony. The bond market has spent years below more
normal long-term yields while unprecedented accommodation was stuffed in the
system. It is highly probable and reasonable to believe that the bond market needs
to spend some time above the long run yield level. That, by definition, is how an average is
Now that the fixed income market has begun to adjust, losses
are piling up and will soon be reported to investors. The size of these losses are sure to shock the
investor community that has grown accustomed
to steady gains from fixed income. In fact, when people open up their monthly account
statements and see excessive losses from bonds yielding low single digits, the
second movement in this symphony will begin. Disappointed bond investors will soon put in
sell requests and leveraged bond managers who were the last marginal buyer of
bonds will have to turn into sellers.
Market yields will have to adjust higher and find a level that attracts
the unlevered bond purchaser. And that
yield level appears to be much higher.
So what is an investor to do? Many hedge funds are trying to hold off
liquidating bond trades by offering fee rebates to limit redemptions. This is always a leading indicator of more
pain to come. Just like rats that leave a sinking ship before it goes under,
redemptions are starting to line up at many bond hedge funds. These hedge fund captains are offering cheese by
reducing fees which is sure to entice the fat rats. After 10 years of easy
money in the bond market, these fat rats are incapable of swimming and will
choose the cheese. I remember when the over leveraged Long Term
Capital Management hedge fund first started to suffer losses in their bond
portfolio. They incorrectly believed
that if needed, more investor capital would be available to stabilize losing
trades. My advice to investors is to
take a lesson from history and don’t bet on this old proverbial dead cat
bouncing. When markets turn, it’s best
to move back to cash and let the markets readjust. After such a long period of low yields and
limited volatility, this market symphony will have many movements and we are
not even at intermission.