Last week after my negative article about the global bond bubble, one of my good buddies let me know that although he agreed with my analysis, he didn’t think the long fixed income trade was nearly as crowded as I claimed.
He provided a link for a couple of recent stories that were quite negative towards the bond market.
Yup, I have to admit the ferocity at which short term sentiment has soured on the bond market is startling. Whereas this summer, in the midst of the Brexit panic, most forecasters were extrapolating forever falling yields (helped by the fact we are no longer zero bound), over the last couple weeks sentiment has turned quite negative.
Suddenly short bond calls are stealing the headlines:
And herein lies the problem with the current environment. There are so many hedge funds and other fast money types chasing an ever diminishing small pile of returns, the moment there is a short term trend, they all rush to jump on the bandwagon, hoping to hitch a ride to the elusive land of outperformance.
When Brexit proved nowhere near as calamitous as commonly predicted, many of these quick twitch traders found themselves on the wrong side of the Armageddon trade. Loaded up with too many bonds, as the summer wore on, their P&L kept bleeding. Once capital market traders returned from the summer holidays, bond issuance swelled to take advantage of the relative lofty bond levels.
This increase in supply, along with worries the Fed might raise rates sooner rather than later, pushed bond yields out to new short term highs.
But is this the start of the new secular bond bear market? Or is this just noise as the excessively overbought market of the past 3 years takes a breather?
I am not sure. I don’t know if this is the big one or not.
Yet there is one thing I am sure of; the next secular bond bear market will NOT result from tighter Central Bank policies. Oh sure, Central Banks might tighten a little and cause an unwinding of the excessive leverage. But when that causes economies to flounder, Central Banks will be right back with more supportive quantitative easing programs.
The real bond bear market will only occur when Central Banks lose control of inflation. Until then, this is all just cyclical squiggles.
And yes, my pal might be correct that on a short term basis, the fast money has become way too negative. Could these new found bond shorts get squeezed with yet another Federal Reserve pause?
For sure. That’s not just possible, but highly likely.
Although this summer the US economy appeared to be gathering a little bit of steam, during the past couple of months, it has rolled over.
If the Federal Reserve ends up being less hawkish than what Fed President Fischer indicated, then many of these newly minted bond bears might rush for the exit.
On a short term basis, I agree with my pal - bond sentiment is quite negative, and bonds might even be prone for a squeeze higher.
But I completely disagree this also equates to longer term bearish positioning. Precious few investors are worried about the return of inflation. Everyone is fretting about the next 25 basis point move of the Fed, or the tweaking of the BoJ bond buying program. Yet no one thinks that a sustained rise in inflation is even the remotest possibility.
The next great bear market in bonds will result from Central Banks who are too slow to raise rates, not the other way round.
An overly hawkish Fed is the last thing a true bond bear should hope for. If the Federal Reserve cranked rates, then the US economy would tank, and deflation would envelope the globe. Long duration American bonds would become the most sought after asset on the planet.
In the current era of excessive over indebtedness raising rates too early will simply flatten the yield curve and slip the economy into recession.
But what will be the long term consequence of the opposite behaviour? What will leaving rates too low for too long eventually create? The answer is the next great bond bear market.
So while most bond bears are hoping the Fed raises rates, I can’t think of anything worse. Yes, it would work for the short run. But what long term bond bears should root for is a Fed that is clueless to rising inflation pressures and only raises rates when it is too late. Gee, I wonder where we might find a Fed like that?
Thanks for reading,