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Possibly a Tactical Chance for Bonds

This week, I am participating in a school-style debate at the Global Fixed Income Institute’s conferences in Madrid where the question before the house is whether or not inflation will resurface in major world economies in the next five years. As you might imagine, I feel that my part of the debate is the easy part, especially as inflation is pointing higher in the US and core inflation just surprised higher in Europe. However, I am sure the other side feels the same way.

The Institute is interested in this discussion partly to illuminate the question of whether the substantial rise in yields over the last three months or so in all developed bond markets (see chart, source Bloomberg, showing 10y yields in US, UK, Germany and Japan) is indicative of a return of fears of inflation.


The ironic part of this is that I do not believe that the rise in yields has much if anything to do with the expectation for higher inflation. Partly, it is due to a subtle sea change in the way investors are thinking about the prospects for central bank policy – to wit, the possibility (which I see as slim) that the Fed chooses to raise rates meaningfully above zero in the next year, starting in September. But to some degree, the market has been discounting higher forward rates for a very long time. It has been consistently wrong on that point, but the steeply sloped yield curve (the 2y/10y spread hasn’t been flatter than 120bps since early 2008 – see chart, source Bloomberg) implies higher forward rates.


The rise in yields, in my view, is partly related to the prospect for changes in central bank policy, but also partly (and more sinisterly) related to the continuing intentional destruction by policymakers of the ability of large banks and dealers to make markets. We see worse liquidity in more and more markets almost by the day (as predicted five years ago in this space, for example here and here, as well as by many other observers). Less liquid markets tend to trade with more volatility, as it gets harder to move institutional size, and at lower prices since holders of assets need to factor in the difficulty of selling a position. Higher yields are going to happen in any event, and when institutional holders of bonds decide to diversify into commodities or into other real assets, interest rates could rise quickly depending how quickly that meme spreads. Of course, the same is true of equities, and commodities. Asset-allocation shifts will get messier.

I actually think this isn’t a bad time tactically to enter long positions in fixed-income. The Fed isn’t going to be as aggressive as people expect; also, bonds will get some support from investors fleeing fading momentum in stocks. The chart below (source: Bloomberg; Enduring Investments calculations) shows the 52-week price change in stocks. This is one measure of momentum, and a very important one as lots of investors look at their returns in annual chunks. Incredibly, since the latter part of 2012 investors have always been able to see double-digit returns from stocks when they looked in the rear-view mirror. Today, that number is 7.5%.


That’s still a terrific real return of more than 5%, but (a) many investors have very screwy return expectations, (b) many investors are well aware that they’ve been living on borrowed time with a liquidity-inspired rally, and (c) certain quantitative investors place significant weight to momentum, over value, in their investment models.

It’s just another red flag for stocks, but it has become passé to point them out. From the standpoint of a bond investor, though, this is good news because all of those equity owners, when they decide to take their chips off the table, will become bond buyers.

And when that happens, the liquidity issues in fixed-income might cut the other way for a while.

  1. Eric
    June 8, 2015 at 3:58 pm

    “all of those equity owners, when they decide to take their chips off the table”.

    This sounds a bit too much like “cash on the sidelines.” Every seller needs to find a buyer, and there wont be many buyers until some folks start selling their bonds.

    but i agree bonds look ok here. I like munis again. that was one of my few good trades of late (if you remember me harping about them about two years ago) and I ducked out of most of them six months or so ago, and I going back in. The CEFs have nice discounts again too.

    • June 8, 2015 at 6:13 pm

      Yes, you’re right of course although there is a ton of money in actual cash (which is why money velocity is so low – cash balances are so high). That’s not the proverbial “cash on the sidelines” but with higher interest rates it is money that may move out the curve. Actual example: today we moved a client’s entire cash stake, earning -0.10%, to short- and medium-term bonds.

      But a good point to smack my hand on – i hate the ‘cash on the sidelines’ thing. Sloppy thinking on my part.

  2. Eric
    June 9, 2015 at 8:25 am

    Of course, the only folks who can actually take that cash off of the market is you-know-who, and of course if they start doing THAT in earnest, rates will go up, not down. The rest of us can only move the cash around like a hot potato: which also sends rates up. But I guess I think that cash is going to sit where it is for a while.

    • June 9, 2015 at 9:04 am

      I’ll add one caveat to that, because I used to puzzle about this a lot. Cash can also leave financial markets for real markets. That is, I can sell stocks to put in a new pool, buy a house, etc.

  3. Eric
    June 9, 2015 at 1:00 pm

    Doesnt the seller (of the house, or the builder of the pool) have to put that cash somewhere? Even if I buy the concrete from china, the seller has to buy bonds with the money, or more likely, buy yuan from a currency trader, who now has the cash to buy something in the us with.

    • June 9, 2015 at 2:01 pm

      Yes, but they don’t have to put it back into financial assets. Otherwise your argument is approaching a reducio ad absurdum…all buyers have a seller; ergo no prices should ever move as the exact same amount of money is in every market tomorrow as it was today (or, no prices should ever move except for purely fundamental reasons). But we know that isn’t how it works – one side demands liquidity at a price.

      • Eric
        June 9, 2015 at 2:39 pm

        If they dont put it into financial assets, they will spend it with someone who will. The only _real_ way money can leave financial assets is by being retired. A bond can mature. A company can liquidate its assets and pay out a final dividend, etc. otherwise, I dont see it.

        Its not a reductio at all. Prices change because the amound of incentive people need in order to buy or sell can change. In other words: tom has cash, mary has a bond, and arthur has stock. If mary sells her bond to tom, and then uses the cash to buy stock from arthur, prices might not change at all. Unless arthur is desperate to sell his stock. then he might take only half of tom’s cash in exchange. mary might be guarding her bond very jealously. she might be willing to sell it to arthur for the half of tom’s cash he has, but only be willing to give a quarter of it to him for that. etc. Its not about money coming and going out of assets. that happens but rarely. (bonds mature a lot, but they are usually turned around for a new one. companies rarely liquidate). Its about whether the buyers and sellers are the more eager ones that determines price changes almost all of the time. When people become EXREMELY eager to sell, say, stocks, prices can plummet with very little stock or money changing hands, let alone having any money come into or out of the market.

        Short version: its true that money does go into and out of financial assets sometimes. but a)its very minor (for stocks its only IPOs and liquidations) b)its definitely not required to explain changes in price.

      • June 9, 2015 at 3:36 pm

        Okay, so then our difference is merely semantic. When I say “money is coming out of financial assets into real assets or consumption,” what I mean (expressed in your terms) is that “people are more eager to transfer money to real assets from financial assets than vice-versa.” Which doesn’t seem that unreasonable.

  4. Eric
    June 9, 2015 at 3:49 pm

    Exactly. But you have to be careful with that kind of shorthand, because it leads people to think that when stocks are “sold” (which really only means that: the stock sellers are going to be more eager than the stock buyers) those sellers now have money to spend that didnt exist before, and now there will necessarily be bond “buyers,” or whatever other fallacious conclusion. But nothing about stock sellers being more eager than stock buyers entails that those stock sellers will be more eager to buy bond than existing bond owners will be eager to sell. The shorthand of “money is coming out” makes it sound like it has to “go into” something else. But it doesnt.

  1. June 9, 2015 at 4:05 pm

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