The Bond Market Explained

We occasionally turn the volume up on the TV`s just to hear what others are thinking in mainstream business media with the Sales & Name Game that is business television these days and CNBC asked the following question: “Why if everybody is talking about inflation is the bond market not moving?”

Frankly, there is so much market illiteracy even among the professionals in the financial market as witnessed by the conversation revolving around high frequency trading, even by the so-called experts who commented publicly on the issue it should be expected that many market participants fail to understand the bond market dynamics regarding why yields are so low relative to expectations at the beginning of the year.

So here goes: 1) Bond yields rallied to the close of 2013, and they were at very elevated levels. 2) Equities were also at all-time highs. 3) The first quarter was tough for two reasons weather, and an exceptionally front loaded 3^rd and 4^th quarters that left slack in the inventory and spending cycle. 4) Lots of low interest money available from many fronts, see Japan, China, US and Europe. 5) Makes sense given the cheap money available, yields at relative trend range highs, equities range bound, and economic data suffering because of an extremely debilitating winter and Growth Pull from Robust 3^rd & 4^th quarters, to put on massive yield chasing conservative carry trades. These were conservative given the aforementioned unique set of points coming together just right.

Here is the trade borrow at rates from 10 to 25 basis points, and I mean borrow in exceptionally large terms (leverage), then depending upon the currency one borrowed in (there may be currency machinations involved in getting into the currency where wanting to invest this cheap loan, i.e., sell Yen and buy Dollars), then pick a ‘perceived’ low volatility asset that pays some form of Yield, i.e., 10-Year at 3%, Utility Stocks with High Yields, etc. buy this yielding asset and sit back and rake in the delta each day, week and month!

It is important to remember these key points regarding this trade 1) Low volatility instruments 2) Exceptionally Low Short-term Borrowing Rates 3) Leverage, Leverage, and more Leverage. This is why Gold has been out of favor the last couple of years because it pays no Yield! When in doubt follow the money trail, and there has been a huge amount of money made by utilizing this trade setup.

Another requirement has to do with the market going in the direction that these investors put their vast leverage to work (or at least stays within a defined range that investors are comfortable with before losing more principal than they earn in interest carry, i.e., utility stocks going higher or bond prices going higher with yields lower).  Also depending upon the currency borrowed in a Positive Carry enhances the trade and an extremely negative carry negates this trade altogether in many cases. Google this if interested but not the scope of this piece.

Many investors have put this trade on and off over the last five years of QE, and recently the Big Banks have been buying up a bunch of the treasuries that the Fed is no longer buying from the start of 2014 going forward.

I imagine this is a way to offset other areas like mortgage refinancing where they were struggling with rising rates, and everybody already effectively refinanced. The Big banks are always looking to make money and this trade sure has helped their bottom line the first two quarters of 2014.

I might also add that bonds are seasonal in nature, and many hide in bonds during the sell in May Summer doldrums. But make no mistake the reason yields are so low right now is because there is money to be made from such a market dynamic.

Carry trades are very popular in the history of modern finance and Big Banking, and the use of massive leverage is their go to strategy where they lack creative talent who can confer a competitive market advantage – Big Banks have no talent! This is an oversimplification but anybody who is really talented can make so much more money working in other places, compensation is off the charts in some cases.

Thus to sum up the Carry Yield Trade is the main driver of why Bond Yields are so low and utility and other high yielding stocks are so high. This trade works until it doesn’t, and it is my guess that many Big Banks figure they have the entire second quarter before they need to start unwinding this trade.

I think they have much less time, and are pushing this trade trying to pick up pennies in front of a massive steamroller of inflation coming down the road. I think the writing on the wall may be as soon as 6 more trading days and the ADP Employment Report, I sure wouldn`t want to own a bunch of treasuries going into next Friday`s Employment Report or the Fed Meeting in a couple of weeks!

But at any rate, once the Fed starts to raise rates and usually they are forced to by rising inflation (they never do it until their hand is forced) all the sudden the cheap money dries up, but long before that happens investors all start to unwind the trade, other investors pile on in the direction of the unwind, and this is where the steamroller analogy comes into play.

As massive unwinds the size required to make this kind of trading strategy work are really hairy, and oftentimes cause more losses than the money made in the prior two quarters making money on this trade by the Big Banks. However everything is quarterly results oriented and being on bonus track on a daily basis at some firms so long range foresight is often lacking in trade configurations. Did I mention a lack of creative talent at the Big Banks who often substitute brut size and scale to make money in the markets as their best investment strategy?

So the High Yield Carry Trade is why Bond yields are where they currently reside, and is this saying anything structural regarding the economy? No! Will these low yields persist through year end? Again No! And remember when in doubt follow the money, and high yield chasing earns a lot of pennies until it gets steamrolled!