I thought the bond market would bounce yesterday. Sentiment was terrible, the month end rebalancing effect meant pension funds and other multi-asset managers would be bidding for fixed income, and the bond market was deeply oversold. Conditions seemed perfect for a short term bounce.
But instead, the bond market went offered and pushed down to new lows for the move.
At this point the bond sell off seems to have gone on longer than a Phish tune. It has been relentless and unwavering. Every slight uptick has been met with more selling.
Although I had been one of the biggest bond bears out there, I covered my short too early and like a chump, have been waiting for a rally to sell. I am relearning the hard way the lesson that true bear markets never give you a chance to get back in.
I have reflected on my mistake, and tried to determine where I went wrong. I realize I have been too focused on Trump being the reason for this move. Sure, Trump was the catalyst, but there is a lot more going on.
My worry has been that the backup in yields, with the corresponding US dollar rise, has been “too far too fast” and that the global financial system would be unable to handle the change. I fretted the bond market was expecting too much from Trump, and that once the repositioning was complete, the pressure from the tightening of financial conditions would cause the old credit destruction cycle to resume.
And who knows, that scenario might still play out. After all, there has been a stupid amount of fixed income buying over the past few years and the repositioning might just be taking a little longer than I thought. It is easy to forget, but it was less than a month ago some really smart people were convinced deflation, not inflation, was the main worry for the global financial system. Everyone, and I mean everyone, was positioned for a benign inflation environment. Eight years of failure to ignite the inflationary fires had taught them interest rates only go one way. Since the credit crisis of 2008 investors of all levels of sophistication have been chasing yield.
And in doing so, they have shunned risk assets.
It could be Trump’s bluster has simply caused the greatest short squeeze in history. All these investors were positioned for moribund growth and tame inflation, and even the threat that Trump might be successful in changing this dynamic has forced them to sell bonds and buy risk assets. Maybe Trump’s plans will fall flat on their face, but that won’t matter for months and months. In the mean time, we have almost a decade of investors hiding in fixed income to unwind.
If this is the case, then I have news for all the stock market bears. The money fleeing bonds has to go somewhere. Even though stocks are stupid expensive, they can get a lot more expensive. Eventually rates will rise because the government is competing for capital, and that point it will make sense to worry about the stock bond relationship. But right now rates are rising because of a shifting of growth expectations, and that money will not sit in cash. So although I hate to say this, the stock market will probably continue to rise. Of course US stocks are extremely overbought and due for a correction, but I don’t buy the argument that bonds will cause stock market to crash in the short run. Bond selling just creates more fuel for the stock market.
Up until now I have argued the recent bond and stock moves are the result of poor positioning by market participants. But what if Trump’s plan actually works?
What if he ends up actually lighting the giant amount of monetary fuel that has been heaped on the global economy over the past eight years? We have become numb to the absurd amount of monetary stimulus Central Banks have pushed into the global financial system. Somehow buying $100 billion dollars of bonds (and in some cases even riskier assets than bonds) a month has become normal. These numbers are not normal. They are bat shit crazy. And even though everyone became convinced they would never cause inflation, what if they are wrong?
My father has retired to a farm. Growing up I can attest he was never one to do much “by the book.” When we had to build a dock for our cottage, he just wandered over to crown land and cut down a couple of nice straight big white pines for the dock’s base. His friends used to laugh that one day the building inspector would show up and ask to see the stumps. Today on his farm, in the summer months he hires a couple of university students to clear brush and clean up the forest areas. They pile all the felled trees and brush into a pile. There it sits all summer, drying out, and getting bigger, and bigger. Well, my old man waits for the fall, and then lights it. The first time he did it he told me he underestimated how big of a fire it would create. The flames leapt a couple of hundred feet into the air. He couldn’t get within 300 feet of it because the blaze was so intense. And it’s not like he does this in a middle of a field. Nope, he does it in a clearing in his forest. He admitted that it scared him and he has now cut back the size of the pile.
That’s the perfect analogy for Central Banks’ monetary madness. They have been piling fuel on the fire for eight years, and although so far it has not lit, one of these days it will take off in an inferno that scares them even more than my father’s hare brained stunt.
I didn’t think Trump would be the spark. I didn’t have much faith his tax cuts would be anything more than policies designed to help the rich pay less, with a token cut for the middle class. I was skeptical of his infrastructure plans. They once again seemed more like giant tax breaks for his developer buddies than true needed infrastructure development.
But yesterday his Treasury Secretary made some comments that forced me to rethink my assumptions.
Americans should expect the “largest tax change since Reagan,” with federal tax cuts for average income earners as well as U.S. businesses, President-elect Donald Trump’s nominee for Treasury secretary said Wednesday.
“There will be a tax cut for the middle class,” banker, movie producer and former Goldman Sachs partner Steven Mnuchin told CNBC’s Squawk Box in his first public comments on the incoming administration’s economic priorities. “Any tax cuts that we have for the upper class will be offset by less deductions to pay for it.”
Across the board tax cuts for everyone but the rich? Well, I’ll believe it when I see it. But for the first time I began to realize Trump might actually do what he said.
And then Mnuchin followed up with a comment that was dear to my heart. From Bloomberg:
Steven Mnuchin, President-elect Donald Trump’s nominee for Treasury secretary, said Wednesday that he would consider issuing 50- or 100-year U.S. government bonds as a way to lock in such low borrowing costs.
It’s about time! For the past year I have been confused about everyone’s myopic views about low long term rates. To me it has been glaringly obvious. Low long term rates are a signal that governments should be spending more, and borrowing longer. The market has handed governments an unbelievable opportunity and they have all been too chicken shit to hit the bid. Governments should be selling as many long term bonds as the market will let them. They should steepen the yield curve.
Although there was some good economic news yesterday, I actually think Mnuchin’s comments were what sent the bond market spiraling lower. The long end led the decline.
Maybe, just maybe, Trump’s team has figured it out. Before you categorize me as some sort of Trump supporter, let me assure you - I find many of the things he says despicable. I am still amazed his making fun of the disabled reporter didn’t sink his campaign right there and then (and lest you tar me as a Clinton supporter, don’t worry - I think her behaviour with the Clinton foundation is a pathetic reflection of everything wrong with the political system). But who cares what I think about politics? As traders we should all put aside our political views and trade what is, not what should be.
And there is a chance Trump has finally lit the monetary fire that everyone thought could never be lit.
This post is running long and I should really get to work, but I wanted to leave you with the following thought. Don’t underestimate the amount of monetary fuel that has been heaped onto global financial system during the past eight years. If this is truly the lift off point, then assets will move like we have never seen before. There will be epic moves that defy all logic. Some of those will be lower, but a lot of them will be higher. There is a very good chance Central Banks will lose control of the financial system. Throw out the rule book of what “can’t happen.” Hang on tight, it’s going to be a wild ride.
Thanks for reading,