bonds


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It’s one of the most important questions this year: Where are bond yields in the United States heading next? For Jeffrey Sherman the answer seems to be obvious: «Up», he signals with his thumb while at lunch at the Los Angeles headquarters of DoubleLine Capital. The Deputy Chief Investment Officer at the renowned fixed income boutique of bond king Jeffrey Gundlach expects more turmoil for financial markets and draws parallels to 1987, the year of the monster crash. At this time, the lively and approachable Californian spots the most attractive opportunities in the commodity sector since commodities tend to perform well in the late stage of the cycle.

Mr. Sherman, tensions in the financial markets are rising. As someone who likes financial history, what are your thoughts when you look at the big picture?
From a short-term perspective, it sure feels like 1987: a little spookiness in the stock market and yields rising. So there are a lot of parallels to 1987. For example, tariffs, a weak dollar and a new Fed Chairman. And remember, there was the crash before the crash. That year, the stock experienced some jitters already in April and about six months later you had the big crash on Black Monday.

That day in October 1987 the Dow Jones suffered its biggest loss in history. At that time people pointed to electronic trading and new financial products like portfolio insurance. Do you spot similar risks today?
People blame quants, people blame algorithms, people blame risk parity. But I’m not convinced. The reason we had this sell off is not algos or risk parity. It’s because of humans. For instance, we all have been told that ETF buyers are buy and hold investors forever. But they’re buy and hold investors until they’re not, until they panic. That’s why these websites for electronic trading like Betterment and all the other Robo-Advisers were down on February 5th. I think even Fidelity had an issue because of the huge volume. So why did all these people try to log in? They weren’t logging in to buy, they were logging in to sell!

What’s next for stocks?
I think you’ll see it again. If bond yields rise you are going to see another scare. It’s the velocity, it’s the speed at which this correction happened: 10% in roughly three to four days, that’s a big move. But what’s interesting is that the bond market was not behaving in a manner which is consistent with the recent past. It didn’t seem like it wanted to rally. Bond yields essentially ended flat that week if not slightly higher. To us, that causes us pause. It means that this correction was an equity market story and bonds weren’t even paying attention to it. Basically, the bond market said: look we continue to trade on fundamentals. We have bigger deficits, we have a growth story, so yields need to be higher.

So what has changed in the bond market?
What has changed is the tax cut. The tax plan really started in the middle of September and that’s when you saw the bond market reacting. That’s when President Trump felt he had to do something and it took him and congress the rest of the year to get it done. At that point, the market had shifted from its disinflationary mindset to a moderate inflation mindset. And that’s the repricing that has been taking place.

Is the tax cut really a game changer for the US economy?
As critical as people were initially of the tax cuts, the cuts are beneficial in 2018 for roughly 98% of the working class. That means that there is more money to be spent or saved. Also, there is something about paycheck growth versus one-time bonuses. In the former case, people tend to spend more, especially people low-income earners because they are the spenders by definition. They don’t make enough money to save. So I think there is the potential to get a little bit of inflation. Because if it is that expansion from the consumer, it will look growthy, but it will also look inflationary. But how long it persists is the multi trillion-dollar question.

What’s more, the tax cuts will bloat the deficit even more. What’s your take on that?
We have an administration and a Congress which want to spend money. For instance, Senator Rand Paul was filibustering for about two hours, ranting about the increase in the deficit and then voted for the tax plan. It’s hypocrisy. So I think they will continue with this deficit binge.

How will this impact the midterms in fall?
People are speculating if the Democrats are going to take over. Socially, they probably could. But they are going to have a hard time economically to take over either the House or the Senate; simply because the tax cuts are going to trickle through and many workers are going to get the benefit of minimum wage. So even the people who aren’t truly getting a tax cut are getting a pay hike. They are going to say: “Look how well we did.” So for the Republicans the timing is beautiful. But I think it reverses in 2020. That’s something we have been talking about for a few years: It’s not the 2016 election that really is the one that’s going to be a pivot. It’s going to be 2020. The reason for that is that the deficits are going to explode, and this administration seems to love debt.

And how do you cope with political risks like the Muller investigation form an investor’s perspective?
The Mueller investigation looks bad. I mean that thing gets worse every week or two. But markets don’t care. They only care if there is an impeachment and then you will get a short-term correction. But it’s very hard to impeach the president. Even if the Democrats get it in one arm of congress they would have to get it through the Senate. So they would have to go to trial in the Senate and the Republicans still have a blocking majority there. And the Republicans showed that they’re loyal to Trump. So it’s practically impossible. But there is always political risk in the world. And typically, the flight to quality trade is what works. That’s why you own high quality bonds like Treasuries, Japanese government bonds and things like that.

So where are US bond yields heading in 2018?
I think we’re going to 3.25 to 3.5% on ten year Treasuries. We broke through most levels on the ten year bond and on the thirty year bond. They have broken their downward channels. Coming in the year it was like: “Hey, we will probably test 3% on the ten year by the first half of the year. Then in January it turned into: “You know, it’s probably the first quarter”. Now it’s maybe March because the bond market does not want to rally. But it’s not just technicals. We’re talking about the Fed’s balance sheet, we’re talking about expanded deficits and we’re talking about less revenue coming in for the government. Don’t forget tax cuts aren’t free.

What does that mean for the new Fed chief Jerome Powell and his plans to tighten monetary policy further?
In March he’s going to hike the Federal Funds Rate. But if you want to hike interest rates three or four times this year plus do the balance sheet unwinding then I think we’re going to have a problem early 2019. I think the financial markets will respond and that’s not good for risk assets. So I’m not convinced that the Fed will take this entire path because I think it becomes painful. This was all set up by Yellen around a year ago. Since then, a lot of fundamentals have changed in the debt market. The plan was set up when yields were lower and before we were set to double the deficit. So it’s really hard to say how the path will look like for the Fed. That’s why we were all listening and watching how Powell behaved when he took the stage this week. It looks like the Fed is going to be more hawkish. But If you want to finance all that debt, you kind of need some dovish people on the board of the Fed. You don’t really want Hawks on there.

Where do you see the biggest risks if something goes wrong?
It’s not that we are extremely bearish on the world. But if rates go up it will put some upward pressure on spreads. And if you respect financial history, what the Fed has always done is hike until something breaks. We definitely had the debt build up. Looking at debt to GDP, people talk a lot about a bond bubble. But it’s not in the treasury market and it’s not in the housing market. It’s in Corporate America.

What’s wrong with Corporate America?
Many companies really lived on due to this low interest rate environment. Zombie companies, those that earn less than they pay in interest, are on the rise again. That’s why you have to watch the corporate market. Right now, it’s not a problem. But let’s say we go to 4% on ten year Treasuries. Does a 6% high yield bond make sense? Probably not. It’s probably 9% or 10% because you have to worry about refinancing. So this is something that hasn’t really happened historically. In fact, the high yield market lived through the entire secular bond bull market. So if we go into this structural bear market, the junk bond market is toast. You are going to have 30% to 40% default rates. That’s extreme thinking. But let’s just take it back down: A 4% on the ten year bond seems completely plausible. So how do you think these risk assets respond? And what does it mean for other markets? People have become complacent with high yield bonds. They assume they don’t default hardly ever. But we know that’s not true. There’s a reason they carry this kind of rating.

Junk bonds tend to act more like stocks in their market behavior than other bonds. What’s your outlook on equities?
One of the most dangerous things is naive extrapolation. Last year, most equity markets advanced more than 20% in dollar terms. So I think some of the risk this year is this naive extrapolation of this recent experience. It’s this recency bias that people think that it just can continue forever. So the risk is that people get complacent and think that equites can always go up.

What is your recommendation when it comes to investing in stocks?
In the US, it’s very difficult to say stocks are cheap. In terms of valuations, when you think about the Cape ratio for instance, you have roughly a 33 ratio on the US market, something closer to 22 to 23 on Europe and about 18 on emerging markets. So what you see is that the European market and emerging markets are a lot cheaper. Also, if you buy into this thesis that we will continue to have this coordinated global growth story, then the emerging markets should be the biggest benefactor. So the ideas is that if you want to deploy new money into equities it’s probably best to kind of shy away from the US because everybody knows the story about the tax reform already. US stocks are priced I won’t’ say to perfection but to a pretty rosy scenario. So if yields push significantly higher it’s really hard on a discounted cash-flow basis to rationalize all of that.

So where do you spot more attractive opportunities for investors right now?
Commodities is our choice investment for investors to get diversification at low prices. It’s an area that tends to do well late in the cycle. It’s a fundamental story.  The consumption side has been increasing and there’s upside to that. If we go from 3.5% global GDP growth to 4% that changes the consumption dynamics significantly. Also, commodities are cheap by historical levels which means it looks like they have room to run. People have kicked them out of their portfolios because of how bad they did for years. It’s an asset class that has underperformed the S&P 500 since the financial crisis every year. But if you get some inflation it’s going to be exhibited in this part of the market. Commodities aren’t perfect on inflation. But they’re pretty good when you have changes in unexpected inflation – and that’s what investors are waking up to.

And which commodities do like most?
I like industrial metals. Copper is kind of iffy at times. However, there’s a strong case for nickel due to demand from electric vehicle production. And if we get growth, zinc still looks interesting because it’s used in galvanizing steel. So I think industrial metals have momentum. I’m optimistic for the precious metals as well. If we do get inflation signs you will see that in the gold and silver price. What’s more, I still think oil goes higher. I think demand will pick up and we will get back to $80. Maybe not this year. Maybe it takes two years. But if the growth story is true the energy market is too cheap still.

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Furthermore, the effective float of 10-year and longer U.S. notes and bonds is relatively small and greatly distorts the bond market signal.   We have written about this several times.

…how small the actual float of longer-term marketable U.S. Treasury securities is available to traders and investors. The data show the Fed owns about 35 percent of Treasury securities with maturities 10-years or longer. Note the data only include notes and bonds and excludes T-Bills.

The Fed’s holdings combined with foreign ownership of longer maturities — more than 1-year — exceeds 80 percent of marketable Treasuries outstanding. The Fed combined with just foreign official holdings, mainly, foreign central banks, is 65 percent of maturities longer than 1-year. Thus, almost 2/3rds of tradeable Treasuries longer than 1-year are held by entities with no sensitivity to market forces.  –  GMM, March 2017

Given the small float of tradeable Treasury notes and bonds,  the market is subject to both massive short squeezes if it gets too far offside and rapid ramps if traders algos try and game duration.

Information Positive Feedback Loop
Many in the market,  we fear, are being hoodwinked by the flattening yield curve, however.  It’s purely the result of technicals and not economic fundamentals.

Nevertheless,  some still look to the badly distorted bond market as a signal of the health of the economy and act accordingly.   Such as delaying capital spending;  becoming more risk averse;  and cutting back on consumption, for example.

A flatter yeld curve also makes bank lending less profitable.

This could thus lead to what George Soros calls “reflexivity“,  a feedback loop where the negative, but false, signal from the bond market actually causes an economic slowdown or leads to a recession.   So much for efficient markets.

Recall the famous line of one prominent market strategist during the dark days of the great recession,

“ We’re in a depression. That is what the bond market is telling us.”

Or the ubiquitous,  “what is the bond market telling us?”    Come on, man!

The Fed Needs To Start Selling Longer Dated Securities
It would, therefore,  behoove the Fed to sell some of its longer dated Treasury holdings in order to steepen the yield curve.

The follwing table shows the Federal Reserve’s holdings of U.S. Treasury securites and the total Treasury outstandings for each year.  This table does not include T-Bills.

If the Fed were to just let its balance sheet “run off” — that is not rollover maturing notes and bonds — it would cause additional pressure on short-term interest rates even as policy rates are rising.  It could also  potentially invert or further distort the front-end of the yield curve and destablize the money markets.

Looking at the data in 2018 and 2019  large maturities are coming due, of which, the Fed holds about 25 percent of the total of Treasuries maturing.

Rolling a portion of these maturities and selling longer-dated securities would probably cause less disruption in the market and be a more optimal strategy of reducing the Fed balance sheet.

Notes and Bonds_June13

Announcement Effect
Just announcing the fact the Fed was contemplating such a strategy of unloading longer dated Treasuries first would cause the yield curve to steepen.   The market would  begin to front run the Fed.  Bill Gross & Co. would kick into action and start “selling what the Fed wants to sell.”

And because there are so relatively few Treasuries outstanding with maturities longer than 10-years,  it is unlikely it would cause the bond market debacle, which many believe is coming.  The total stock of Treasury securities with maturities longer than 10-years is smaller than the combined market capitalization of just Apple, Google, and Amazon, for example.

If bonds become too oversold, the Fed could easily engineer a short squeeze to bring the yield curve back to where it desires.

Recall, the Fed losing control of the yield curve prior to the financial crisis to foreign central banks recyling capital flows back into the U.S. bond market is what Alan Greenspan singles out as the major cause of the housing bubble.   The Fed moved the funds rate up 425 bps and the 10-year and mortgage rates barely budged.

During the 2004-07 tightening cycle, the era of the Greenspan bond market conundrum, for example, the 10-year yield managed to rise only a maximum of 64 bps during the entire cycle from a beginning yield of 4.62 percent to a cycle high yield of 5.26 percent. This as Greenspan raised the fed funds rate by 4.25 percent, from 1.0 percent to 5.25 percent.  – GMM, March 2017

Risks
The major risk is that foreigners begin to sell.  But where will they go?

Spanish 10-years at 1.43 percent?  German 10-year bunds at 0.266 percent?  How about a 10-year Japanese JGB at 0.067 percent?    In fact,  low foreign yields and the ensuing portfolio effect is keeping the U.S. 10-year note well anchored below 2.60 percent and another factor distorting the yield curve.

Central banks could also be forced to sell some of their $4 trillion U.S. Treasury holdings if global currencies come under pressure via-a-vis the dollar.  To maintain currency stability, monetary authorities could be forced to intervene in their foreign exchange markets.

Such was the case with China over the past few years, which experienced a major bout of capital flight.  The PBOC suffered a loss of FX reserves close to a trillion dollars, some of which were held in U.S Treasuries.

Credit and Equity Markets
That is where we could have some short-term problems and overshooting.   But our sense, many are waiting to pounce on a sell-off in the spread and equity markets.   Too many pensions are underfunded and too many seniors are yield strarved.

Having some dry powder makes sense.    It’s coming and you will have to act fast.

Conclusion
A sustained spike in inflation?

Tilt!  Game over, comrades.

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Asymmetry in the market deals with probabilities and expectations. Probability is nothing more than a math calculation that tries to deal with uncertainty or the unknown, which is of course the future.

Volatility is low. Lower than it has been for, well almost forever. Articles are being written on how low volatility is, what it means, is this a new paradigm, etc.

Obviously this is a time to buy volatility, that should it return, could provide that asymmetrical outcome sought. My favourite target in these circumstances are yield hogs. These chaps buy high yield, mostly junk, for the returns as against say treasuries.

With volatility so cheap…you can buy volatility a long way into the future, to allow time to work in your favour, for pennies. That will be my trade on Monday when the markets re-open. My candidate is prepared.

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The Trump rally raged on this week with all major U.S. indexes hitting record highs, but despite the historic run, David Stockman is doubling down on his call for investors to sell everything.

“This 5 percent eruption is meaningless. It’s some robo machine trying to tag new highs,” Stockman said Tuesday on CNBC’s “Fast Money,” in a dismissal of the S&P 500 rally.

“I see a recession coming down the pike in 2017. The stock market is going to go down and it’s going to stay down long and hard because, for the first time in 25 years, there’s nothing to bail it out.”

This echoed the initial call Stockman made Nov. 3, when he urged investors to sell stocks and bonds before the presidential election.

However, since the Nov. 8 election, the Dow Jones industrial averagehas gained 4 percent en route to surpassing 19,000. Additionally, theS&P 500 and Nasdaq also hit record highs in the same time period, gaining 3 percent and 4 percent, respectively.

Yet Stockman, who was director of the Office of Management and Budget under President Ronald Reagan, reaffirmed that markets are heading for disaster.

“My call stands. Sell the stocks, sell the bonds, get out of the casino,” Stockman explained to CNBC in an off-camera interview. “Bonds have already cratered by nearly $2 trillion worldwide and have miles to go. This isn’t a rotation into stocks, either. It’s the greatest sucker’s rally ever.”

Stockman, author of “Trumped: A Nation on the Brink of Ruin… And How to Bring It Back,” lamented that there will be no Trump stimulus or Reagan-style boom. He further added that he expects “an unprecedented fiscal bloodbath” resulting from the $20 trillion worth of debt that the U.S. currently has on the books.

“This isn’t Ronald Reagan with a clean $1 trillion balance sheet and with a fluke GOP and a Southern Democratic coalition that only materialized because he got shot,” Stockman said in reference to John Hinkley Jr. attempting to assassinate Reagan in Washington, D.C., in 1981. “Nor is it LBJ in 1965 with a thundering electoral mandate and a massive congressional majority for the Great Society.”

On the contrary, Stockman, who initially predicted that Trump would win the election, added that Washington will be in chaos by June. This is because he anticipates ongoing disruptions from the tea party, which Stockman doesn’t foresee as allowing additional deficit increases.

Furthermore, Stockman doesn’t believe that Trump can pass a bipartisan stimulus plan without capitulating on his promise to repeal and replace Obamacare. Additionally, Stockman cast serious doubt over Trump’s ability to enact a meaningful tax cut or to develop a major infrastructure program. If so, Stockman believes that could very well trigger a civil war within the Republican Party.

“So when the recession hits this summer, the Fed will be out of dry powder and fiscal policy will be paralyzed,” concluded Stockman. “This time the market will crash and stay crashed.”

Given this prediction, Stockman re-emphasized that gold and cash will be king and urged investors to shift their portfolios accordingly. He also recommend shorting the S&P 500 through ETFs such as the SH or theSDS.

Gold-is-Not-an-Investment

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Jeff Gundlach, Wall Street’s bond god, thinks the world of monetary and fiscal policy is about to pivot.

“How in the world could we be talking about rates never going up when in fact rates have bottomed?” he asked the crowd of investors at the Grant’s Interest Rates Observer conference in New York City on Tuesday.

He explained that it was on July 6th when he decided that the narrative that benchmark interest rates around the world would stay lower for longer was “getting quite old.”

He cited several reasons: inflation is picking up, the dollar did not strengthen after the Federal Reserve raised rates the last time. Also there’s this:

“In the investment world when you hear ‘never’,” ( as in rates are ‘never going up’), “it’s probably about to happen,” said Gundlach, who is CEO of DoubleLine Funds.

Urgent

Now, an uptick in inflation and the dollar’s tolerance for higher rates are factors that don’t necessarily require urgency. And generally without urgency there is no change in policy. They are also factors he discussed in his last presentation, ‘Turning Points,’ back in September.

But there is one thing that has changed since then. That thing is Deutsche Bank.

“You cannot save your faltering economy by killing the financial system,” said Gundlach.

That is, in effect, what low rates do. Over the last few weeks the world has watched as Deutsche Bank has struggled to convince investors and the public that it is in a sound fiscal position. Two weeks ago the US threatened the bank with a massive $14 billion fine for transgressions that led up to the financial crisis, and the bank’s stock really started to plummet.

In euros, Deutsche Bank’s stock price has hovered near the single digits.

“There’s something about big banks being in the single digits that makes people nervous,” Gundlach said.

He believes that Germany will bail out Deutsche Bank, despite the fact that the government has said that it intends to do no such thing. The problem isn’t Deutsche Bank in his mind, though — it’s other banks in a similar position that don’t have countries like Germany to bail them out.

He mentioned Credit Suisse, arguing that Switzerland can’t handle a banking catastrophe its size.

So what will the new world order be if rates must go up to save international banks?

“I can bring back inflation by 5:00 pm by giving everyone $1 billion. The lines at BMW lots would be a sight to see,” he joked.

What he’s saying is that now is the time to pivot to fiscal stimulus. Both presidential candidates Donald Trump and Hillary Clinton have talked about spending hundreds of billions on infrastructure and other investments. Meanwhile, US debt to GDP has been stable since 2011, and no one is really talking about the deficit anymore.

Here’s a key chart he showed to the crowd. It was also in his last presentation:

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Demand for stocks that offer high dividends and for bonds saddled with record-low — and even negative — yields has shaken up the traditional use of bonds and stocks in portfolios.

“Investors are buying bonds for capital appreciation and stocks for income. The world has turned upside down,” said James Abate, chief investment officer at Centre Asset Management LLC.

The shift, according to Abate, has been fueled by central-bank stimulus inflating government-bond prices across the world, pushing yields on nearly $12 trillion of government debt into negative territory.
And as bond yields tumble, more and more equities are yielding more than government bonds, spurring demand for companies offering sustainable income in the form of dividend payments.

“It is a poison brew that central banks keep serving us,” Abate said.

Treasury yields have tumbled for six straight weeks, falling to record-low levels on Friday despite hiring news that suggested the economic expansion remains intact. On Monday, as the S&P 500 marched to an all-time high, yields moved somewhat higher but were still hovering near all-time lows.

Meanwhile, since the beginning of 2016, so-called dividend aristocrats SPDAUDP, +0.58% , which include companies that have raised dividends for at least 25 consecutive years, have outperformed the main stock indexes, rising 12.5% so far this year, compared to 4.8% for the S&P 500 SPX, +0.78% and the Dow industrials DJIA, +0.69%

On the corporate side, the yields on higher-rated, investment-grade corporate bonds have also been dragged lower in the global bond rally, mainly due to foreign demand from investors fleeing negative interest rates abroad.

As a result, a rough survey by Jefferies’ global equity-strategy team showed that at least one-third of S&P 500 stocks offer dividends higher than the same company’s bond yield.

And yet, investors don’t seem to be discouraged by anemic yields and demand for bonds “seems to be insatiable,” said Aaron Kohli, interest-rate strategist at BMO Capital Markets, who thinks the bond market is now expensive.

Last week, inflows to U.S. fixed-income funds and ETFs jumped to $7.95 billion, the highest inflow since February of 2015, according to a report by Bank of America Merrill Lynch released Thursday and charted below.

Bank of America Merrill Lynch
“There’s a perception there’s a greater fool behind you,” Kohli said, pointing to the strategy of buying a bond with the intention to sell later at a higher price.

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Not to worry just yet, just returning to trend.

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