The global bond market speculative melt-up has brought new meaning to phrase “indiscriminate buying.” I know it’s heresy to suggest as much, but we’re witnessing history’s greatest speculative Bubble go to absolutely “crazy” extremes (it will all have been obvious in hindsight).
What others celebrate as a “fantastic bull market,” I see as Abject Monetary Disorder. With global bond prices spiking parabolically upward, how much systemic leverage and resulting liquidity is being created in the process? What quantity of global fixed-income has been purchased on leverage? More importantly, what is the scope of derivative-related leverage that has accumulated throughout global bond markets and fixed-income, as seller/writers of myriad strategies are forced to purchase the underling debt securities to hedge derivative contracts previously sold.
There is increasing evidence of market dislocation and associated Monetary Disorder… Where’s all this “money” coming from?
A market week that began with a U.S./China trade “truce” ended with much stronger-than-expected (224k) June non-farm payrolls data. There were new intraweek record highs in equities and no let up in the global yield collapse. Lacking was increased clarity as to prospects for trade negotiations, economic growth and central bank policy.
Almost a week after Presidents Trump and Xi agreed to restart trade negotiations, there are few details as to what was actually discussed and agreed upon. The ratcheting down of tensions was widely expected in the markets. As anticipated, President Trump chose not to impose additional tariffs on Chinese imports. The softening of sanctions (allowing purchases from U.S. suppliers) on Huawei was the major surprise, although even on this point there is murkiness. After push back from U.S. security “hawks,” the administration stated the Chinese tech powerhouse remained blacklisted and had not been granted “general immunity.” Little wonder there was no mention of the Huawei concession from Chinese state media, only warnings of the U.S. propensity for “flip-flops.”
Analysts have generally responded cautiously to the “truce” and to prospects for an imminent trade deal. Equities, in the throes of speculative impulses and record highs, celebrated the reduced odds of near-term negative trade surprises during at least a temporary cooling off of vitriol.
Global bond markets, enjoying their own speculative melee and attendant unprecedented low yields, were fazed neither by the “truce” nor surging risk markets. German 10-year bund yields were down eight bps at Thursday’s lows, to a record negative 0.41%. French yields were down 13 bps for the week at Thursday’s record low negative 0.14%, with Swiss yields down another 12 bps to Thursday’s record low negative 0.67%.
As spectacular as it’s been at Europe’s “core,” the yield collapse at the “periphery” has been nothing short of astonishing. Italian 10-year yields traded as low as 1.55% Thursday, down a stunning 112 bps from the end of May. At Thursday’s 2.01% low, Greek yields were down 150 bps since May 15th. Portuguese 10-year yields were as low as 0.27% in early Thursday trading, after trading at 2.00% in November and 1.16% in May. After beginning the year at 1.41%, Spanish yields traded Thursday at 0.20%. At Friday’s close, Denmark’s 10-year yields were at negative 0.30%, Austria’s negative 0.13%, Netherlands’ negative 0.22%, Finland’s negative 0.10%, Belgium’s negative 0.02%, Sweden’s negative 0.02%, Slovakia’s 0.05%, Ireland’s 0.07%, Slovenia’s 0.11%, Cyprus’ 0.45% and Croatia’s 1.09%.
I’ve witnessed a lot of “crazy” in my three decades of closely following various Bubble markets (i.e. Japan’s Nikkei ending 1989 at 38,916 (closed Friday at 21,746); manic early-nineties buying of Mexican tesobonos; late-1993 collapsing U.S. yields and Bubble excess that portended the 1994 rout; speculative Bubbles in SE Asian securities and Russian bonds; LTCM with $2 TN notional derivatives exposures; Internet and tech stocks in 1999; and $1 TN of new subprime CDOs in 2006; etc.). Yet nothing compares to the ongoing global yield collapse.
The global bond market speculative melt-up has brought new meaning to phrase “indiscriminate buying.” I know it’s heresy to suggest as much, but we’re witnessing history’s greatest speculative Bubble go to absolutely “crazy” extremes (it will all have been obvious in hindsight).
According to Bloomberg, the amount of negative-yielding debt globally jumped Thursday to a record $13.4 TN. Rising almost $2.2 TN over the past month, “negative-yielding debt now comprises 25%” of the total investment-grade universe.
July 5 – ETF Trends.com: “According to the latest report on exchange-traded fund (ETF) flow data from State Street Global Advisors, fixed income exchange-traded fund (ETF) inflows were out of this world in the month of June, garnering over $25 billion. ‘Even with a 6% rally in global equities, investors allocated a record amount to fixed income ETFs,’ wrote Matthew Bartolini, CFA Head of SPDR Americas Research State Street Global Advisors… ‘Equity ETFs did garner $20 billion of inflows. However, inflows to bonds were truly out of this world with over $25 billion –a more than 45% increase over the prior record from October of 2014.’ The record number of inflows into bond ETFs allowed for record capital allocations into the fixed income space. ‘Bonds’ record June haul pushed the first-half figure to $74 billion, which is also a record amount for a first half,’ Bartolini noted.”
What others celebrate as a “fantastic bull market,” I see as Abject Monetary Disorder. With global bond prices spiking parabolically upward, how much systemic leverage and resulting liquidity is being created in the process? What quantity of global fixed-income has been purchased on leverage? More importantly, what is the scope of derivative-related leverage that has accumulated throughout global bond markets and fixed-income, as seller/writers of myriad strategies are forced to purchase the underling debt securities to hedge derivative contracts previously sold.
In contemporary derivatives-dominated markets, upside market dislocations create the outward appearance of endless liquidity. Indeed, the higher markets spike the more previously “out of the money” options (swaps, swaptions, etc.) move “in the money,” requiring more aggressive “dynamic” buying to hedge rapidly escalating derivatives-related exposures. Such “melt-ups” are powerfully self-reinforcing, with buying on leverage exacerbating liquidity excess and eventually culminating in panic buying.
There is increasing evidence of market dislocation and associated Monetary Disorder. While “money” supply data have lost relevance over the years, it’s worth noting M2 “money supply” has surged almost $210 billion over the past six weeks (up $638bn y-o-y) to a record $14.773 TN. Money market fund assets have gained $150 billion in nine weeks to an almost decade high $3.192 TN (retail money market funds included in M2). And in another indication of liquidity abundance, outstanding Commercial Paper has jumped almost $80 billion in five weeks to an eight-year high $1.164 TN. Where’s all this “money” coming from?
This week had somewhat of a capitulation look to it. After ending last week at 2.10%, Italian 10-year yields had sunk an incredible 55 bps at Thursday’s 1.55% low. Greek yields were down 42 bps for the week at Thursday’s 2.01% low. Elsewhere, Hungary’s 10-year yields were down 36 bps – India 31 bps, Turkey 70 bps, Lebanon 61 bps, Mexico 27 bps and Brazil 24 bps – at Thursday’s lows. Turkey’s dollar bond yields were down 39 bps for the week at Thursday’s 6.88% low.
The problem with speculative melt-ups – especially when dominated by speculative leverage and derivatives-related buying – is reversals tend to be sharp and problematic. In derivative “dynamic” trading strategies, virtual panic buying to hedge exposures during the market’s upside blow-off phase can abruptly reverse into aggressive selling as prices turn lower. Market liquidity, seemingly so permanently abundant during the ascent, is prone to quickly becoming almost non-existent into the decline.
Global bond markets reversed sharply after Friday’s stronger-than-expected 224,000 gain in June non-farm payrolls (we’ll see Asia’s response Monday). Two- and five-year Treasury yields jumped 10 bps in Friday trading (to 1.86% and 1.83%). Ten-year yields rose eight bps to 2.03%. Ten-year sovereign yields jumped 10 bps in Canada, seven bps in Italy and Greece, eight in Spain and 10 bps in Portugal.
A Friday afternoon Bloomberg headline: “Fed Debate Shifts From Large Cut to Whether to Cut at All.” While it did dip slightly in early-Friday trading, by the end of the session markets were back pricing a 100% probability of a rate cut at the Fed’s July 31st meeting. Fed funds futures imply a 1.81% Fed funds rate at the end of the year, up from Wednesday’s implied 1.63%.
Curiously, the market is still highly confident of a rate cut this month, this despite record stock prices, a trade “truce,” and a sharp snapback in job creation. Markets are clamoring for a rate cut and few believe the Powell Fed will risk a repeat episode of disappointing the markets. Yet there’s a strong case for the Fed to hold steady on rates.
July 2 – Bloomberg (Christopher Condon and Brian Swint): “Loretta Mester has laid out the argument against a rate cut this month, while many of her colleagues are leaning hard toward it and investors assume it’s on the way. The president of the Cleveland Fed… said her baseline forecast calls for slower, but still solid, growth of around 2% in 2019 — even as she acknowledged that downside risks are on the rise. ‘Cutting rates at this juncture could reinforce negative sentiment about a deterioration in the outlook even if this is not the baseline view,’ she said. A cut ‘could also encourage financial imbalances given the current level of interest rates, which would be counterproductive.’”
A Reuters article (Marc Jones and Navdeep Yadav) quoted Mester: “The markets have priced in rate cuts, my interpretation is that they have put a lot of lean on that weak growth scenario. We don’t want to throw away what the market is telling us… You want to infer a signal from that but some of it is noise and some of it is signal, and the markets have shown they are not always correct about where the economy is going.”
It’s a quandary. When markets go into speculative melt-up mode, the signaling process turns dysfunctional. Technology stock prices in March 2000; record high equities in July 1998 and October 2007; and sinking bond yields in late 1993. Never before have so many securities (bonds and stocks) been held by passive index products; and never have algorithmic trading strategies played such an impactful role in the marketplace. Moreover, never have global securities and derivatives markets been so closely interconnected. And of perhaps most consequence, never have central bank policies had such profound impacts on global bond prices, market perceptions and speculative trading dynamics.
Central bankers are now faced with the predicament of having nurtured distorted markets (with aberrant signals) that will throw a frenetic tantrum if central banks don’t follow the markets’ directive. There is bold discourse aplenty these days regarding the merits of an “insurance” rate cut. Chairman Powell himself has stated “an ounce of prevention is worth a pound of cure” – a comment markets have interpreted as guaranteeing a July cut. Pundits, including former central bankers, have been speaking as if there is essentially no risk to a cut they believe would offer protection against bad outcomes. This, however, completely disregards the risks associated with adding monetary stimulus to dislocated global securities markets already in dangerous detachment from fundamental realities.
With a rate cut cycle commencing imminently, the popular view is that the fixed income investment cycle is closer to the start of something than the end. Yet it sure has the look of the craziness that comes at the end of a long cycle. That central banks are prepared to further loosen monetary policies with global securities markets absolutely booming should be sounding the alarm bell. Central bankers will either hand over the keys to the asylum – or try to regain control. Either way, there is market uncertainty and volatility on the horizon.
It used to be that seasoned market players would fret late-cycle excess (appreciating associated fragilities created). But that was before “whatever it takes” QE and $13 TN of negative-yielding global bonds. Why not buy 10-year Treasuries at 2.00% when bunds trade at negative 0.37%. Why not own U.S. investment-grade bonds at historically (highly) elevated prices that appear attractive relative to negative-yielding European corporates? Junk, even better. MBS, why not. Basically, virtually the entire fixed-income universe is expensive on a fundamental basis – yet cheap relative to negative-yielding foreign bonds. And imagine how high U.S. stocks might trade if Treasury yields go negative?
Market speculation used to be grounded in “the greater fool theory”. Who needs a fool when markets have central bankers with the wizardry of their QE tool. Bonds have been around for centuries, but we’ve finally reached the point where there is no longer a ceiling to bond prices. This is a precarious juncture for global markets, and the Fed should think twice before it feeds this beast.
Original Post 6 July 2019
Categories: Doug Noland, Perspectives