The Absolute Return Letter  June 2015 – Are bond investors crying wolf?

June 2015

Are bond investors crying wolf?

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To me, consensus seems to be the process of abandoning all beliefs, principles, values and policies. So it is something in which no one believes and to which no one objects.”

Margaret Thatcher

Investment heavyweights challenge the consensus

On a regular basis I challenge the consensus. It is part of my nature, I suppose, but it comes at a price. Let me explain. We were recently contacted by a conference organiser, who would like me to participate in a panel discussion later this year at an institutional investor conference here in London. The subject? Investment heavyweights challenge the consensus.

I was foolish enough to accept the invitation before doing my homework as to who the other panellists would be. When I realised who they are, my heart sank. They are true heavyweights! You can do no more than wish me good luck, but look here if you fancy a bit of light entertainment on 7 October.

Trade du jour

Now to more sombre matters. Bond investors lost serious amounts of money in the bond market rout between mid-April and mid-May. One estimate puts total losses at approx. $0.5 trillion1 - not exactly pocket money for most of us.

I am not sure anything fundamental has drastically changed, though. Real rates accounted for virtually all the increase in interest rates between mid-April and mid-May (chart 1). As pointed out by Barclays in a recent research report, had the sell-off been the result of QE doing its job, i.e. improving economic fundamentals, breakeven yields would have moved much more. Hence the sell-off was predominantly an unwind of term premia – not the result of enhanced economic expectations.

Having said that, the EU economy did perform somewhat better than expected in Q1 and, as a result, deflation fears abated. In the months leading up to the rout being long bonds had become pretty much one-way traffic. So convinced were investors that the ECB would prolong the 35 year bull market in bonds that it had  become the trade du jour. We don’t know yet who lost the most, as few have announced results for the month of May, but it wouldn’t surprise me if parts of the hedge fund community ended up with a fair amount of egg on their face.

So desperate were many investors to pick up the ‘easy’ profits, they forgot to use common sense. As Ambrose Evans-Pritchard pointed out recently in The Daily Telegraph2:

Contrary to mythology, QE does not work by lowering bond rates. It works through a different mechanism: by causing banks to "create" money.”

Or as I wrote in last month’s Absolute Return Letter:

I don’t expect interest rates to make a dramatic move upwards for many years to come. However, lessons from Japan have taught me that, even if rates stay comparatively low, they can easily move 0.5-1.0% over a relatively short period of time, and a 1% move in the wrong direction can do a lot of damage to the P&L.”

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I don’t think the current flight from bonds is any more than that - a brief spell of panic attack. The long bond trade simply got immensely crowded, and investors (speculators) ended up paying a hefty price. I have two reasons for not believing this is the beginning of something much bigger, but before I go into those I suggest you take a quick look at chart 2a-b. The two charts illustrate precisely the same – German 5-year bond yields. Only the time horizon is different, and what a difference it makes!

When looking at chart 2b, it is hard to imagine that $0.5 trillion could have been lost (worldwide) as a result of what looks like a blip on the curve. In the bigger scheme of things it is indeed a very modest move. That alone tells you how crowded the trade had become.

How will the Federal Reserve Board (and other central banks) unwind QE?

The bond bears have argued for quite a while that the ultimate unwinding of QE - whenever it happens - will inevitably push interest rates higher. The Fed (and, by implication, other central banks as well) simply cannot avoid doing considerable damage to interest rates when it eventually begins to unwind its very large balance sheet that is the result of years of QE – or so the argument goes.

I disagree. Of course central bank action could ultimately have some impact on interest rates but nowhere near the levels which are often suggested by the drama queens amongst us. In the following, I shall use a presentation given recently by Stanley Fischer, Vice Chairman of the Federal Reserve Board, to the Monetary Policy Forum. It was called Conducting Monetary Policy with a Large Balance Sheet, and if you haven’t already read it, I will urge you to do so (you can find it here)

First and foremost, as pointed out by Stanley Fischer, QE in the U.S. has actually been limited in scope compared to many other countries when measured on a relative basis, i.e. as a % of GDP (chart 3).

Secondly, it is not the intention of the Fed to engage in wholesale selling at any point in time. As Stanley Fischer said in his speech:

Finally, with regard to balance sheet normalization, the FOMC has indicated that it does not anticipate sales of agency mortgage-backed securities, and that it plans to normalize the size of the balance sheet primarily by ceasing reinvestment of principal payments on its existing securities holdings when the time comes.”

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