bonds


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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.

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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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To understand why this is so, it helps to introduce the concept of the equilibrium real interest rate (sometimes called the Wicksellian interest rate, after the late-nineteenth- and early twentieth-century Swedish economist Knut Wicksell). The equilibrium interest rate is the real interest rate consistent with full employment of labor and capital resources, perhaps after some period of adjustment. Many factors affect the equilibrium rate, which can and does change over time. In a rapidly growing, dynamic economy, we would expect the equilibrium interest rate to be high, all else equal, reflecting the high prospective return on capital investments. In a slowly growing or recessionary economy, the equilibrium real rate is likely to be low, since investment opportunities are limited and relatively unprofitable. Government spending and taxation policies also affect the equilibrium real rate: Large deficits will tend to increase the equilibrium real rate (again, all else equal), because government borrowing diverts savings away from private investment.

The real interest rate does not have to be consistent with full employment of labour. The real interest rate can be equivalent to the profit margin, or, average profit margin, of productive business.

When business profits are high, the economic incentive to borrow money rises. Consumers demand more of the good or service that can currently be supplied, therefore prices [and profits] reflect this. New entrants, attracted by the high profit margin enter the field, or, established business expands using borrowed capital. As more businesses enter profitable areas of business, demand for capital rises, which causes a rise in the cost of capital, unless savings increase [supply of capital] commensurate with the demand for capital.

If business profitability is lower than the cost of capital, business will not borrow. If the supply of capital should rise, then the cost of capital will fall. If the cost of capital falls below the profit margins of business, once again there will be a potential demand for capital.

Employment is a cost of production. Employers will hire labour to the point of marginal profit of labour. When that point is reached, no further labour will be engaged. Again, the higher the profitability of the business, the higher the marginal productivity of labour will be and the higher the employment in that business will be.

When the Federal Reserve sets interest rates and set them low as in ZIRP, the cost of capital is set below the profit margins of almost all productive business. No longer is capital allocated to business with the highest profit margins, which are the businesses with the highest consumer demand, capital is allocated to sub-optimal business with low consumer demand.

This ties up and increases the costs of raw materials used in production away from profitable business to marginal business. ZIRP is counter productive. ZIRP distorts the market. ZIRP prolongs the life of low profit businesses [businesses with low demand for their goods and services] and increases the costs of production of profitable businesses through increased competition [prices] in higher stages of production.

Bernanke misunderstands the effect of artificially created low interest rates by the Federal Reserve. The necessity of lowering interest rates in 2008 was caused by a liquidity crisis. A liquidity crisis is a result of fractional reserve lending, which in the 2008 crisis was driven largely through real property speculation.

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