Bonds: Strange Days Indeed

It was only a few short months ago I was looked upon as if I was suffering from paranoia, seeing monsters in every corner of the market. No many of my subscribers think I have gone mad because I don’t see the obvious signs of a U.S. recession. Meanwhile, equity fund manager and/or strategist after another is on the air waves telling us to that there is no fundamental reason for equities to sell off. A JPM Funds strategists was in CNBC late Thursday afternoon telling viewers to not pay too much attention to the bond market as it was “manipulated.” As I heard this while listening in my truck I could not see what see looked like, but by the youthful tone of her voice, she sounded as if her biggest financial worry during the last period of market volatility (2007-2008) was about catching the latest sale at American Eagle (how are they doing lately?).

Although central banks might influence the interest rate markets more than in the past, trust me, the 10-year UST yield would not be sub-1.70% if bond market participants were not concerned about disinflation. More telling is the yield of the 30-year U.S. government bond. At the time of this writing, the yield of the 30-year government bond stood at 2.52%. This is significant as the so-called long bond is the ultimate arbiter of inflation. It also has the least amount of central bank influence of all U.S. Treasury notes and bonds. Thus, can often be the purest measure of the bond market’s inflation expectations. It is often even a better inflation pressure than TIPS breakevens as TIPS prices are often influenced by retail investors, either directly or via mutual funds and ETFs. With the 30-year yielding around 2.50%, it is a good indication that bond market inflation expectations have fallen.

This in itself is not all that alarming as it signals lower inflation and not necessarily slower growth. However, the fact that one central bank after another has adopted negative interest rate policy indicates that the source of low inflation might have shifted from low energy prices to lower rates if of growth. I believe that many investors, advisors and market participants have become accustomed to extreme central bank accommodation. They now see low policy rates, even ZIRP, as normal. Those under the age of 30 know nothing else! This is surprisingly similar to what has transpired in Japan. Two generations of Japanese have come to see very low interest rates and low rates of economic growth as normal. They have adapted to these conditions so successfully that the Bank of Japan has had to engage in multiple rounds of QE and, finally, NIRP.

The willingness of investment strategists (a particularly those of the more youthful variety) to accept low rates, ZIRP and NIRP as normal is astonishing. Market participants have grown less confident that central banks can boost economic growth. In fact, judging by the global capital markets’ response to the latest rounds of NIRP, it appears that market participants believe that NIRP will do more harm than good. It looks as though the jig is up for central bankers.

What about the strong December Nonfarm Payrolls and JOLTS data. What about the strong wage data? They were filled with anomalies and are somewhat backward looking. They tell us what labor market conditions were then. Even if one was to believe that business executives were hiring because they were optimistic about the economy two months ago, the recent tightening of credit conditions, plunge in equity prices and the perceived need for negative interest rates probably have corporate executives quaking in their boots. In fact, recent comments by some corporate executives have a dour tone.

For years, risk asset markets pushed higher, fueled by a little bit of good economic data and a lot of central bank hope. Today we are left with only a little bit of good economic data. I fear that the little bit is going to get littler as it was the energy and materials boom which shouldered much of the economic load until 2014. That growth engine has all but seized. Fortunately, the U.S. service sector has improved to take the baton from commodities. However, as China is now demonstrating, a service economy engine produces less economic horsepower than an industrial economic engine. Although the U.S. will probably avoid a recession, it is doubtful that U.S. GDP will average much above 2.0% for the foreseeable future. If China worsens, global GDP could be dragged lower. The U.S. will not be immune.

The bond market has been auguring for this scenario since 2014, when long interest rates began falling again, in spite of Fed tapering resulting in fewer bonds purchased by the Fed. The Equity markets joined the party in 2015. What we are seeing today is a repricing to an economy which no longer has the benefit of neither an energy boom nor Fed stimulus.

The Fed is in a corner. If it eases or goes to NIRP, benefits are unlikely. If it tightens, it could strengthen the dollar, further pushing down commodities prices and make life more difficult for U.S. multinationals. However, the Fed wants to tighten because it does not want a Japan-like situation where low rates, low growth and high savings rates become the norm. Further Fed tightening could also provide benefits to the global economy by making it somewhat less necessary for foreign central banks to engage in ZIRP and NIRP. If the U.S. dollar rises, it is possible that foreign currencies weaken. NIRP might be short-lived as it has done nothing to calm markets or weaken currencies for that matter. What is next, more QE?

I fear that ZIRP, NIRP and QE might be the new normal policy. However, growth and inflation under those conditions will look anything but normal for anyone over the age of 30. Thus, traditional asset allocation models will not work. My strategy is to take on more duration risk, less credit risk and focus equity holdings on companies with business models and balance sheets built like battleships. The days of pie chart portfolios of bond, stock and alt ETFs are likely over. Now, portfolio management will require hands on the wheel.

Have a great long Valentines weekend.