The Bond Market Explained for Mohamed El-Erian by EconMatters
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On Thursday Mohamed A. El-Erian was on CNBC`s Halftime Report and he said something that a lot of people have been saying regarding the bond market, and it needs to be cleared up, because the amount of poor understanding regarding the bond market by people who make their living, i.e., are in the financial market business is astounding. It is even more mind blowing given that Mohamed A. El-Erian actually worked at a Bond Firm in PIMCO, and helped manage Harvard` s endowment in the past.
Just Mirrors What Everybody Else Says
He reiterated what many have said, and I will paraphrase that the Bond Market and Stock Market are telling you two different stories about the economy. This is just flat out wrong, and shows a poor understanding of what has been going on in the Bond Market ever since QE and zero percent interest rates became the default central bank policy. And frankly it is a mistake that should never be made by someone who worked at PIMCO, a firm that specializes in bonds for goodness sake! I know his role was mainly to represent PIMCO and go on Television, and create exposure for the firm, but he has access to the best minds of the industry every day, and he is completely clueless when it comes to such an important distinction regarding the bond market. Moreover, since many people make this same mistake I thought I would clear this false notion up once and for all regarding bonds.
The Bond Market Basics Explained
Here goes the Bond Market just like the Stock Market is a long oriented market, what that means is that right now we are in a Bull Market for Bonds, i.e., price is going up. When I say long oriented, this is with regard to price and not yield, long oriented refers to the fact that many of the participants are long only, they don`t short bonds, they don`t short bond futures, they only invest from the long side of the market, i.e., they only buy bonds, so by default they are long price and not yield.
Long-Oriented Market: Pension Funds, Insurance Firms, 401k Money, Bond Funds
This is similar to the Stock Market as 401k money doesn`t short the stock market or the bond market, generally speaking investors either designate money to go into bond funds or stock funds from the long side. The same could be said for many insurance companies, pension plans etc. they only buy bonds, and just as the majority of the stock market participants have a bias or predilection to play from the long side of the market, the same can be said for the bond market.
Bond Vigilantes have been “Bought Out”!
The days of the ‘bond vigilantes’ dyed a long time ago in the united states, they were prevalent in the European Mess a couple years ago before Mario Draghi gave an implicit backstop that killed this vigilante movement. So by nature the bond market is a long biased market, and investors are loving the bull run in bonds, just like the bull run in stocks, and throughout this loose monetary experiment, bonds and stocks have spent the majority of the time both being in full bull market mode, it is because of the liquidity provided by ZIRP & QE Infinity where the Fed is outright buying bonds.
Focus on Price, and Not Yield
So the fundamental mistake it to think in terms of a low yield telling you anything about the economy, as it is price that you should be focusing on, and for the same reason that stocks are near all-time highs is the same exact reason bonds are near all-time highs in price. Lots of liquidity to buy assets, all assets whether it is commodities, stocks or bonds. To repeat stocks and bonds are not telling you two different things, they are telling you the exact same thing: There is a bunch of cheap money sloshing around the financial system thanks to ZIRP and QE Infinity!
[As an aside, sure the German 10-Year yield is lower because Europe is struggling right now and it started going lower when investors tried to front run European QE as a possibility, however whether the German Bund is 1% or 1.3%, it is also primarily low in yield for the same exact reason that all bond yields are low, Global ZIRP by Central Banks creating massive liquidity in the financial system, i.e., borrow cheap and buy anything resembling an asset, as there is more liquidity than there are assets to purchase! This is one sign that you have a destructive Global Monetary Policy by Central Banks that incentivizes poor and inefficient capital allocation strategies by financial players.]
ZIRP Equals Bull Market for All Assets!
Basically, since the beginning of ZIRP both stocks and bonds have been in a bull market, and have had a considerable headwind at their backs pushing “PRICES” up! ZIRP for the most part has rendered the old relationship of Bonds and Stocks being ‘opposing’ markets obsolete, i.e., when things are bad in the economy the bond market is in bull mode, and when things are good then the stock market is in bull mode, there is some of this relationship on the margin, but not like in pre-ZIRP days! In other words the Federal Reserve has completely destroyed this relationship through ZIRP and QE, and it is one of my major criticisms of the program, the Fed should not be involved in financial markets, this is not their purview!
It`s all about making money!
So the only thing the bond market is telling you Mohamed A. El-Erian is that thanks to ZIRP there are a lot of investors thinking they can make money being long bonds, just like stocks, whether it is for the yield arbitrage carry of zero percent borrowing, or the price appreciation because so many people are pre-disposed to be long bonds, and there is just so much liquidity in the system and too few assets period whether they are stocks, bonds, commodities or rare artwork, in the end it is all about making money.
The bond market is long because they think they can make money, they don`t give a rat`s ass about Europe`s economy or geo-political concerns, only so as it helps their current already long disposition. [Sure Geo-political concerns have some investors truly seeking safety, but more than anything hedge funds are front running this tendency, and crowding into the trade, but whether the 10-year is 2.40% or 2.6% is really minor relative to why it is below 3% yield in a 2.5% GDP growth environment, and this is a result of ZIRP and an abundance of cheap money with a need to be put to work chasing returns. If you cancel ZIRP overnight the 10-year yield wakes up