Virtually anyone looking at the markets today can sense that something is a bit amiss, that there is a disconnect with reality. The hard part of making use of such a sense is quantifying just how out of whack things are, and when the inevitable reality reconnect will occur. Especially when dealing with cycles that can last much longer than the typical stock market whipsaw each decade. Perspective is important, as is watching the long-term indicators — more and more of which are showing overheated markets.
We started our ‘Nowhere to Run’ series with looks at the wildly overvalued stock market, and a bubbly housing market. Today we tackle the world’s biggest market: bonds, and their unsustainable valuation.
The policies of Federal Reserve and other governmental agencies have resulted in an unprecedented situation: bubbles that span across all risk assets, leaving investors with few places to invest their money other than in those very bubbles. With one notable exception: precious metals.
Right now precious metals are currently at historical — even multi-generational — lows vs. stocks, bonds, and real estate. Unsustainable debt issuances have underpinned the longest uninterrupted asset-price inflationary cycle ever: US federal debt, global government and corporate debt, personal debt from student loans to auto loans to credit card debt, all at record highs. The result: rarely have gold or silver looked so compelling relative to other assets.
Relative to, most certainly, the bond market.
These days, you can find any number of talking heads who will say that this century’s great bull market in stocks is getting long in the tooth:
It’s essentially risen steadily for over nine years without a significant pullback, more than quadrupling in value.
Due for a more significant correction? As we discussed two weeks ago, almost certainly.
Fact is, though, there is another bull market that is less frequently talked about, even though it has been raging four times as long.
Bond prices increased by a factor of more than seven between the early ‘80s and 2018.
Here’s a picture to noodle on:
Interest rates on 30-year Treasuries peaked at 15.21% in October of 1981. That’s 37 years ago. Despite a brief spike in the mid-80s, the trendline since then has been steadily down, with the bottom reached in July of ’16 at 2.11%. At the time of this writing it’s hovering just north of 3%.
Remember that the price of bonds are inversely correlated with interest rates. So a long downtrend in rates means an equally long bull market in prices.
That bond prices and yields are inversely related -- when one goes up, the other goes down -- is important to understand, as any movement in interest rates back up, like we’ve seen starting in the U.S. for the first time in many years, could mean deflating the biggest bubble possibly ever created.
A Little Bond Math
A bond is a fixed-income security. It is issued with a face value (called par) that never changes, an interest rate (known as the coupon) which also never changes, and a maturity date, when you get your money back. But the bond’s actual yield does change because its price rises or falls, relative to its par value, with every fluctuation in market demand. When there are more sellers than buyers, the ask price from the seller must go down to encourage buyers; when there are more buyers, the ask price increases. The relationship can be expressed in a simple equation:
Y = C / MP X 100
Where Y is effective yield percentage, C is the Coupon, and MP is the current market price. So if you hold a $1000 par value bond with a 3% coupon at issuance, and interest rates double to 6%, then the bond’s market price drops to $500. Conversely, if interest rates drop to 1.5%, your bond will be worth $2000.
If the bond bubble is so enormous, then why isn’t the frontpage of every news site plastered with the details? Simple: recency bias on steroids. If people have short memories from one stock market crash to the next, then consider:
If you graduated college and began a career in finance or journalism in 1981, you are now nearing retirement age without ever having experienced a bear market in bonds in your adult life. If you traded them continually during those four decades, you have done very, very well, almost in spite of your abilities. If you reported on them, they’ve been nothing but Steady Eddie.
At this juncture, it’s worth clearing up one other point of potential confusion. When people refer to “bonds,” most often they are talking about Treasuries issued by the US Government. Technically, though, the only Treasury bonds are those with a 30-year maturity (T-Bonds). At the other end are those with maturities of less than one year, called T-Bills. All others in between are known as T-Notes, with 2- and 10-year maturities being the most popular.
This “long bond” rate as it’s known is commonly used as a proxy for the bond market as a whole, since interest rates for just about every item in the U.S., and much of the world, is linked one way or another to this rate. It’s the safe haven, default, background rate for the world’s reserve currency. In other words, if you are to risk your money in anything less safe than the T-Bond — such as lending your money to credit bard borrowers, auto buyers, or a basket of “junk” corporate debt — it better yield more than the T-Bond or you’re not being compensated for that risk.
When the yield on the T-Bond falls, then the yield on that junk bond portfolio can fall with it -- as only the relative risk needs to be priced in -- and the price of the junk bonds will rise as well. Conversely, when the rates of T-Bonds start rising, then those junk bonds have to start paying more or investors just dump them for safer yield, thus prices start falling rapidly: the riskier the asset (higher rates, lower credit ratings, and longer durations) the faster they fall.
The T-Bond’s long length also means that that bond market cycles tend to be long. Very long. Take the counterpart to our ’81 grad, the person who first went into finance shortly after the end of World War II. For the next 35 years, all he or she would have ever known was a bond bear market. Just take a gander at the same chart over a longer period:
As you can see, the glorious bond market of the past 35 years is about equally counterbalanced by the brutal performance of the previous 35. Interest rates soared from the post-WWII years to their peak in ’81 and have been declining since (or since ’85, if you want to start counting at the rebound peak).
Today, the Federal Reserve Bank of the United States, i.e. the Fed, is committed to raising interest rates.
What do we mean when we say that? The only interest rate it directly controls is called the Federal Funds Rate. It’s the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight, on an uncollateralized basis. When the Fed raises this rate, other rates in the market — Treasuries, mortgages, car loans, corporates, whatever — tend to follow it up or down. Makes sense, right? Banks have to charge higher rates to consumers than they charge each other to borrow.
The Fed dropped the Funds rate in response to the 1987 stock market crash. It did the same again in response to the dotcom bubble bursting. It rose a bit between each recession, but never really back to par, hence the trend. They then responded to the financial crisis, taking it down to near zero in 2009, where it sat for the next seven years.
In 2016, the Fed’s Board of Governors decided it was time to reverse course once again, and has been pushing the Funds rate up in small, quarter-of-a-percentage-point increments since then. The latest uptick came in September, and the Fed has said it plans another in December 2018.
Bond prices have been slow to respond. Take the yield on 10-year T-notes, the usual bellwether of the overall market. Earlier this year, it punched through its 30-year trend range (though you may have to squint to see it), which is normally a signal that a reversal is on the way.
Come August ‘18, it continued to only to toy with the 3% mark.
Then, the recent volatility in stocks and other markets started hitting, trade wars heated up, and suddenly the yield moved. As of this writing, they’re above 3.15% — might not sound like much, but it’s not often the 10-year note yield changes by 5% in two months’ time.
And it may only be the beginning. Yields will be heading higher if the Fed stays the course and pushes the Funds rate to, or close to, 2.5% by the end of the year as seems to be the consensus. Prices have to fall — ending, or at least stalling, the long bull market.
But, just because it has to happen doesn’t mean it’s going to happen tomorrow or next month or even next year. Bubbles have their own peculiar ways of enduring well past the point applied logic suggests they should end; where everyone is expecting a pop.
So it’s reasonable to ask: are we in fact in a bubble?
Yes, said former Fed Chairman and ultra-low-rates enthusiast Alan Greenspan in January of ’18. He saw bubbles in both the stock and bond markets, but “the bond market bubble will eventually be the critical issue."
Jamie Dimon, the influential CEO of JPMorgan Chase Bank, concurred seven months later. “I think rates [on the 10-year Note] should be 4 percent today," he said. And, “you better be prepared to deal with rates 5 percent or higher."
That’d be a bull market killer for sure.
But — and it’s a big but — there’s also a wild card: market distortion. And what causes that? Usually, some sort of government intervention. If you look at any of the T-note or T-bond charts, you can see that between 2009 and the end of 2017, when benchmark interest rates on the whole barely budged, the bond-price bull market continued unabated.
Why? Where the market didn’t create demand, the Federal Reserve did. The government tried to boost the economy by taking on more debt. The Treasury issued bonds in enormous numbers and, whenever outside demand dried up, the Fed bought. And bought.
During the three rounds of stimulus that began in late-2008 and concluded in October 2016, the Fed increased its balance sheet by three trillion dollars. More than half of that was government bonds, and nearly all interest-rate-linked debt securities.
Now, the Fed is shrinking its balance sheet. It began in October ’17, selling off $10 billion in assets a month — $6 billion of government debt and $4 billion of mortgage-backed securities. In a series of steps, sales have been increased to $50 billion per month come this quarter. This should shrink its balance sheet by up to $420 billion this year, and up to an additional $600 billion in 2019 and every year going forward until the Fed decides that the balance sheet has been "normalized," whatever that may mean (before the financial crisis the Fed’s balance sheet contained many less trailing zeros, and was nominally more then zero).
No central bank in the world has ever attempted a balance sheet reduction on this scale, and the consequences are unpredictable. What if, for example, no one wants to buy what the Fed is selling? We don’t know.
At the same time, foreign countries are also selling US debt. Russia reduced its Treasury holdings from $96.1 billion in March ‘18 to just $14.9 billion in May (they’ve been buying lots of gold instead). China remains the largest holder of Treasuries, remaining steady at $1.2 trillion because any massive dumping would be a big negative for them as well as us. But what that country will do as the trade disputes continue to simmer and risk boiling over remains to be seen.
And there’s one further wild card: derivatives.
Twenty years ago, the world derivatives market — a shadowy area with virtually no oversight — barely existed. Then it suddenly took off, and by the crisis of ’08, it had reached a notional value of $650 trillion (with a T), and that was considered dangerously explosive territory. Though it backed off a bit during the Great Recession, it continues as an unregulated, over-the-counter market today.
And, it has shot up again in recent years, soaring past its historical peak to as much as $1.2 Quadrillion (yes, with a Q). Its segments include stocks, bonds, currencies, mortgages, energy, and just about anything else you might want to bet on.
This is completely unprecedented, and what it means for markets going forward cannot be foreseen. Some actually see the enormous derivatives market as a stabilizing force, since normal-sized fluctuations don’t budge it. Others see it as a gigantic pile of tinder awaiting the arrival of a match, such as happened with junk mortgages in ‘08.
But for whatever reason, investors continue to prop up the bond market. Maybe it’s recency bias, or irrational exuberance, or faith in derivatives. Or maybe they believe that the market can absorb new debt forever, without triggering a serious rise in interest rates as holders head for the exits. Perhaps they believe the Fed will back off if inflation jumps too much. Perhaps they think they can be among the smart ones, the ones who dismount the bull at the very last minute.
Or all of the above.
To conclude: yes, we believe bonds are in a bubble. And a lot has to go right to keep the bubble inflated. And it may — many, many people’s livelihood and power depend on it. The one thing we’re sure of is that a bubble like this cannot stay inflated forever and, as the old market saying goes, it’s better to be a year early than a day late…
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