One of the most universal consensus calls in the markets today is that interest rates are destined to rise. Thirteen out of 13 major investment banks all think that interest rates for global fixed-income will rise this year. I get nervous when everybody is on the same side of the boat. And so does my good friend and business partner
It's been a busy week here in
Your getting ready for some left-over Super Bowl chili analyst,
Outside the Box
Challenging the Consensus
"The noble title of 'dissident' must be earned rather than claimed; it connotes sacrifice and risk rather than mere disagreement."
Herd mentality is one of the strongest and most powerful human instincts. Humans take great comfort from walking the same path as others have walked before them, and nowhere is this more evident than in the field of investments. Most investors are simply incapable of disregarding the consensus when making investment decisions, if for no other reason than because 'being out there on your own' is associated with considerable career risk (I wrote about this back in
I consider myself a contrarian investor. Not a contrarian for the sake of being a contrarian but a contrarian nevertheless. My inclination to go against the prevailing view is based on one very simple piece of knowledge acquired through 30 years of trial and error. When an investor states that he is bullish, he is more often than not close to being fully invested, hence he has used most, if not all, of his dry powder. Obviously, the more people who find themselves in this situation, the less purchasing power there is on an aggregate basis. At this point the market is at or near its peak. Precisely the opposite is the case when most investors are bearish. They have sold most if not all of their holdings, at which point the market is more likely to go up than down.
This way of thinking is frequently challenged by people (often academics) who argue that it cannot be that way, because investing is a zero sum game. We cannot all sell out at the same time, as someone has to own those bonds, or so the argument goes. Whilst theoretically correct, this view fails to take into account the distinction between core and marginal investors. Whilst marginal investors (e.g. private investors, hedge funds) can, and do, move freely between asset classes, core investors (e.g. pension funds, sovereign wealth funds) are at least partially restricted in their movements. Such limitations ensure that, in practice, investing is not a zero sum game.
Now, when I look at financial markets going into 2014, I cannot recall ever having come across a more one-sided view than the one which prevails. The consensus view on bonds is overwhelmingly bearish while pretty much everyone is bullish on equities - or at least they were until EM equities began to fall out of bed.
Some may argue that the sell-side is always bullish on equities, and while that is not a million miles away from the truth, this year is still uniquely one-sided. And it is certainly not the case that the sell-side is always uniformly negative on the outlook for interest rates. As far as the bond market is concerned, the 2014 consensus is a major outlier, and that is precisely what has piqued my interest. It is much more difficult to obtain reliable information on the buy-side consensus. Suffice to say that none of the information I have at hand has given me any reason to speculate that the buy-side view differs materially from that of the sell-side. See, for example, the recently updated policy portfolio for the
Five reasons you may want to change your bearish view
I agree with the view shared by many that, in the long term, as economic conditions normalise, interest rates will almost certainly rise. I cannot possibly disagree with that. The words to pay attention to, though, are 'long term'. In the meantime, 2014 may contain one or two surprises, effectively delaying the bond bear market.
Now to those reasons, and in no particular order:
The emerging market crisis escalates further;•
The Eurozone crisis re-ignites;•
The disinflationary trend intensifies and potentially turns into deflation;•
The economic recovery currently underway proves unsustainable; and/or•
Flow of funds provides more support for bonds than anticipated.
The emerging market crisis escalates further
Quite a serious crisis has been brewing in some EM countries since talks of Fed tapering first began in May of last year. I first referred to it in the
At the heart of this crisis is a realisation that many EM economies depend on foreign capital to fund their external deficits. That foreign capital is more often than not U.S. dollars. I am not the first to have noted that the 'Fragile Five' all run substantial current account deficits (chart 2).
The other channel through which the U.S. provides liquidity to the rest of the world is its chronic current account deficit. Every dollar of deficit in the U.S. is by definition somebody else's surplus, so when the U.S current account deficit narrows, fewer dollars find their way to other countries. History is littered with examples of deteriorating U.S. dollar liquidity leading to a crisis somewhere, even if it is not always entirely predictable where and when it happens.
The U.S. economy is experiencing a true boom in domestic oil and gas production. In pre-crisis times, the U.S. would import the equivalent of 10-11 million barrels of oil per day (mbpd) to meet its demands. That has now dropped to 7-8 mbpd as a result of rapidly rising domestic production levels. Going into the 2008-09 recession, the U.S ran a quarterly deficit of about
Source: Federal Reserve Bank of
Stage one of the EM crisis was a relatively contained crisis, limited to a handful of countries with large current account deficits. Stage two, which began in earnest early in the New Year, has engulfed other countries such as
All of this has the potential to escalate into a full-blown EM crisis like the one we experienced in 1997-98, even if most EM countries are in much better shape today than they were going into the previous crisis. Remember, there is never only one cockroach! Should this happen (and I am not yet saying it definitely will happen), there will be significant private sector capital outflows from emerging markets seeking refuge in safe(r) havens, like T-bonds, bunds and gilts.
Then there is the ultimate joker, better known as
The Eurozone crisis re-ignites
The problems in mainland
Source: CEPS Policy Brief
The French have, unlike some of their Latin neighbours, managed to escape the worst of the storms in recent years, but this may change soon, provided the analysis above is correct. E280 billion in new capital is an awful lot of money, even for the French, and President Hollande may soon have bigger issues than his private affairs to deal with.
Could the AQR re-ignite the crisis and de-rail all the good work of the last couple of years? It could, but it is not my base case. A central problem in the early days of
Having said that, the very public debate that is likely to follow the publication of the AQR could very well lead to a renewed widening of yield spreads between perceived safe havens and the crisis countries. This is my second reason why bond yields in the U.S.,
The disinflationary trend intensifies and potentially turns into deflation
A more likely consequence of the 2014 AQR is sustained pressure on lending activities across the Eurozone, a trend which is already underway. Most banks in the Eurozone have seen the writing on the wall and are already preparing for higher capital standards. Of the larger countries, only in
Source: Standard & Poors
The Eurozone is probably only one shock away from outright deflation. Consumer price inflation is running at 0.7% year-on-year, and that number is inflated by austerity driven tax hikes. According to
The one shock that would take the Eurozone into deflationary territory could indeed come from an escalation of the EM crisis, or it could come from somewhere few consider to be an issue right now - oil prices. I referred earlier to rising production volumes in
The risk of outright deflation is much lower in the
Underlying inflation is probably softer in the U.S. than it is in the
On the other hand, those who expect QE to ultimately lead to a dramatic rise in inflation rates are likely to be thoroughly disappointed. We are still in the early stages of deleveraging, following the bust of a massive credit cycle (chart 10). Disinflation, or perhaps even deflation, is the natural consequence of such deleveraging - not inflation. Any risk to our central forecast that bond yields will remain largely unchanged in 2014 is thus to the downside (as in yields going down, not up).
The economic recovery currently underway proves unsustainable
U.S. economic indicators have been mixed recently. Home sales, auto sales and capital goods orders have all shown signs of weakness. It may be no more than a wobble or it may be signs of a turning point in the economy but, as
Veneroso goes further in his analysis and makes a very interesting point:
You have to mistrust all the economic data. Why? BECAUSE AT TURNING POINTS IT IS ALWAYS WRONG. Ninety percent of all economic forecasters do not recognize a recession because the preliminary data always says there is no recession. It is only later that the data is revised to show a recession. After having failed to correctly forecast the economy for decades,
There have been some mildly disappointing data releases in the US, but these have been mostly due to an excessive build-up in manufacturing inventories since mid-2013, and the prospects for final demand seem firm.
We will have to wait and see who is right and who is wrong; however, I don't particular like the quality of recent corporate earnings reports. Even to the untrained eye it is pretty obvious that many companies are struggling to deliver the earnings growth expected of them. Massive buyback programmes are used to generate EPS growth, but underlying sales and profits growth is dismal. This cannot go on forever. Given this and all the other factors conspiring against economic growth, the risk to our central forecast is very much on the downside.
Flow of funds provides more support for bonds than anticipated
Now to the fifth and final reason why the bond market could confound everyone this year and deliver positive rather than negative returns - flow of funds. Bond mutual funds hold record high levels of cash (chart 11), supposedly prepared for a sell-off in bonds, but with plenty of dry powder to step in and ultimately provide support, should the anticipated sell-off materialise.
Secondly, U.S. pension funds have had a very strong year on the back of the powerful equity rally and, as a result, have increased the average funding ratio to 92% (http://www.businessinsurance.com/article/20131107/NEWS03/131109861?tags=|307|77|82). Such funding level was not expected to be reached until 2017 at the earliest, and the fact that the industry is several years ahead of its own recovery plan could very well mean that many pension funds decide to take some risk off the table in 2014 and move their funds into what is perceived to be a safer asset class - namely bonds.
Thirdly, foreign investors are often considered to be a risk factor when it comes to the outlook for U.S. bond yields and thus, by default, for bond yields in other developed markets as well (due to the high correlation between bond markets in most developed countries). Such views are often expressed in complete disregard of national accounting identities. The rest of the world's claims on
So, if we know that the U.S. economy will produce a current account deficit of
For all these reasons I am not at all convinced that 2014 will be the year where the bond market finally breaks down, but I have saved my trump card for last. I was recently introduced to a bond research firm called
This asymmetry in expected returns is largely a function of the historically high spread between U.S. 2-year and 10-year Treasuries (the blue line in chart 13 above). On that basis, the smart trade appears to be a spread trade - long 10-year vs. short 2-year Treasuries - rather than an outright short at the long end. For this and all the other reasons mentioned above, I cannot be bearish on bonds, be it U.S. or European.
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