13-02-04 PIMCO @PIMCO
Gross (tweet 1 of 2): Don’t retreat – just be cautious. Central bank check writing creates bubbles/distortions in all markets. What to do??
Gross (tweet 2 of 2): Sell long term bonds. Buy low P/E stocks, TIPS and Italy bonds.
Italian 10-Year notes are yielding about 4.42%.If bonds are topping, what kind of world would that look like? Despite the current optimism about stock prices that’s a question you don’t want answered.
Because of this widespread political dysfunction, we (in the West) are yet to evolve our credit-dependent growth model into something more durable, inclusive, fair and sustainable. Instead, yet another attempt is being made to get one more turn of growth from an exhausted, distortive and partial approach.
So, how should you reconcile these emotions? I would suggest the following for you to consider:
- Temper your optimism with caution: There is a limit to how far central banks, acting on their own, can divorce market pricing from fundamentals.
- Identify the major developments that are needed to validate existing market pricing: This speaks to not just economic, sector- and company-specific issues; it also involves technical factors, including the scale and scope of funds flowing to different market segments.
Bonds are facing headwinds, but a number of indicators are suggesting that they may be stiffer than previously thought. In the opening sessions of 2013, government bonds lost more in terms of price than they earned in 2011 from interest. That's a pretty scary thought, but indicators are telling me that this is just the tip of the iceberg, regardless of Fed bond buying and zero-interest-rate policies.
Top Chart offers the principle reason for my bearishness. It compares the price of the Barclay's 20-year Trust (TLT) bond ETF with our Bond Barometer. The TLT has not been around for very long, so it's been spliced to a price series derived from the yield on 20-year government bonds.
The Barometer is constructed from several trend, momentum and inter-asset components. When it falls to the 50% level or below it goes bearish and earns a red highlight on the TLT plot.
You can see that it has just fallen into negative territory. Bonds hate inflation, so it would be nice to point to some encouraging factors on that front. Unfortunately, the opposite is currently the case, as a similar model for industrial commodity prices has just turned bullish.
Middle Chart reinforces that idea. It features the CRB Spot Raw Industrials, an economically sensitive commodity index. You can see that the momentum for the ECRI Weekly Leading Index, a forward-looking economic indicator, has just crossed above zero. The arrows show that previous crossovers have offered very timely signals that a new commodity bull market is underway.
If U.S. bonds are likely to tank over the next few months, you might think that international bonds would be a safer bet. Bottom chart argues otherwise, since the KST, a long-term smoothed momentum indicator, has been declining since 2011 and has been registering a series of lower peaks in the face of a rising index for the last nine years. This long-term negative divergence is a sign of deteriorating momentum, but what's to stop prices working their way still higher and the oscillator moving lower? Nothing, until the price confirms this weak action with some kind of trend reversal of its own.
That's exactly what happened at the end of January. In this case, the signal was a violation of the very long-term or secular uptrend line. In technical analysis a trendline gains its significance from its length, and the number of times it has acted as a successful launching pad for a rally. This one scores on both counts, as the 12 years it has been in existence is a long time. Furthermore, it has been touched or approached on six different occasions and is therefore an accurate reflection of the underlying trend.
Here is the rub. In the six years between May 2006 and June 2012, the world's six biggest central banks expanded their balance sheets almost threefold from $4.9 to just over $14.09 trillion. When just a fraction of that that money hits the economy, the global economy will unquestionably experience a dose of inflation. Our commodity Barometer buy signal suggests that that process is now underway.
With skimpy current government-bond yields of 2%-3%, it seems to me that the risks completely outweigh any potential rewards. With my bond and commodity models having just moved into an inflationary mode, buying bonds today could be equated to buying stocks in September 1929. A slight exaggeration perhaps, but I think you get the picture. My advice — Sell bonds and buy peace of mind.
What's Driving Intense Volatility in the Bond Market? Three Possible Explanations
Equity investors went home this past weekend feeling pretty proud of themselves. For many who recently (and finally) gained net exposure to the market and after a blistering January, stocks started February with a robust 1% gain. The sentiment has improved not because economic conditions are better but rather because prices are higher.
While all the headlines and attention is going to the equity market, it was the bond market that saw the real action last week as the 143-00 objective I have been monitoring was finally tested. This is significantly more important than Dow 14,000.
If the Fed is successful in reflating the economy in 2013, the Pyrrhic victory could be a real scenario and if it gets traction the market could be under significant pressure and the lower objectives would be in play. Because of the technical nature of the rising channel and important 143-00 level I think on balance there is less margin for error and thus more risk on the downside.
The bond market has been consolidating a relatively tight range for six months and has lulled many participants to sleep. I think this thing is wound up and ready to break out. It’s unlikely that we will be sitting in this same spot next year; which way we go and where we end up is going to have wide-ranging ramifications for the asset markets and implications for the economy.
If the market needs to test 143-00, next week could be a great opportunity. You can see on the chart there is enormous support in the area between 143-00 and the rising channel. The fate of the bull market will bet settled at these crossroads. Expect this area to get vibrated and the reflexivity of the MBS market to play a key role in how this gets reconciled.
US Bond Futures Five-Day Tick
You can see that out of the gate on Monday volatility continued and the pressure was on the downside. On Wednesday bonds took out 143-00 and in an intense session that saw huge volume of 615k contracts turning over the entire open interest in a relatively tight one-point range. The 10-year (TY) futures contract traded 1.86mm contracts and settled basically unchanged. It was a wild day and when you see that kind of volume turn over in an unchanged market, that typically is a sign of a bottoming process as the supply has been adequately absorbed.
However as you could see on Friday (February 1), Wednesday’s price action was only a sign of more volatility to come. After successfully testing 143-00 on Thursday, bonds were right back there on Friday before the NFP release. With the weaker NFP print bonds caught an immediate bid and rocketed back to the highest levels on the week and it looked like 143-00 was going to be made support. The bid quickly faded though. And when ISM beat expectations, the bottom fell out, taking out 143-00 like warm butter and eventually closing at the lowest level on the week in another wild session.
I knew 143-00 would be a critical level but I didn’t expect this kind of intense volatility. What was behind this record level of volume? This was not economic data related, stocks breaking out, or the great rotation nonsense. This was big money whipping around.
There are a few possible explanations as to what is causing this bond market intensity and today I want to go through three ideas -- one new thought that could be having an influence, and two that I have discussed over the past few weeks which seem to be gaining momentum. They are all probably contributing in some form or fashion and the key issue going forward is whether they will continue to put pressure on bond prices.
Why the Fed’s QE US Treasury open market purchase bid to cover ratio has been tracking higher. The bid/cover shows how many bonds were offered in the tender versus how may the Fed bought.
SOMA Bid to Cover Vs. 10-Year
You can see that clearly that the ratio of bonds offered to the Fed has been rising since the beginning of the year, and this excess supply is correlated with the rising yield on the 10-year. Sedacca and I were trying to figure out what was driving this supply.
One possible explanation is the expiration of TAG (Temporary Liquidity Guarantee). TAG insures non-interest-bearing deposits in banks for unlimited amounts and was implemented during the credit crisis so that large cash deposits for corporations used for things such as payroll wouldn’t flee for fear of bank failures. Presumably when TAG expired at the end of the year those deposits would seek other government-guaranteed short term liquid assets outside bank deposits. Why would that affect the long end of the curve?
Banks invested some of these deposits in liquid Treasury, Agency, and MBS duration to earn a spread or carry. According to the Fed’s H.8 weekly report on bank assets and liabilities, during the last six months of 2012 deposits trended higher rising by over $400 billion while holdings of Treasury and Agency securities rose by $100 billion maintaining the recent trend of investing roughly 25% of deposits in securities. Between December 26, 2012 and January 16, 2013, non-time deposits deviated from the general rising trend falling by $88.4 billion, and over the same time their holdings in these securities fell by $20 billion, which is 23% of the reduction in deposits.
According to ICI, in the same four-week period institutional money market funds have increased by $22 billion, which also explains the above-average buying by direct bidders at recent two-year and three-year Treasury auctions. Corporate treasurers aren’t investing liquidity in the stock market so presumably the expiration of TAG can explain some of the selling in the longer duration assets and purchasing of shorter more liquid securities. The great rotation might just be out of cash deposits and into two-year notes. The curve steepening in as yields rise also corroborates this assertion as the two-year/10-year spread has widened 25bps year to date.
As noted, the reflexivity of MBS convexity selling could also explain some of the bond market volume and volatility. As I have mentioned before, due to negative convexity MBS investors hedge their duration risk with Treasuries, buying duration when yields fall and selling duration as yields rise which in extreme markets can exacerbate the move. The 2.00% level on the 10-year is a key psychological level but is also represents a significant pivot point for MBS investors.
Last week BAML strategist Satish Mansukhani wrote in client note that 10-year yield rising to 2.15% will increase convexity risk while further 10bps-25bps rise would generate “significantly higher” hedging needs. To give you an idea of the magnitude of the extension risk, the analyst noted that the previous week’s move extended outstanding agency MBS duration by $177 billion 10-year equivalents. This interplay between MBS and Treasury hedging of extension risk was evident during last week’s volatility but seemed to subside a bit on Friday as MBS outperformed on the day.
The third market element that is behind this intense volatility in the bond market is the continued weakening of the Japanese yen amid further dovish rhetoric. On Friday you may recall S&P futures were already bid up six points before the employment data was released. This was perhaps on the back of comments made by BOJ Deputy Governor Yamaguchi who said that the central bank was making a stronger pledge this time that previously.
According to Bloomberg:
Yamaguchi said in his speech that the BOJ will pursue “aggressive monetary easing” as long as it deems appropriate, adding that the bank’s price target is the same as the “flexible inflation targeting” adopted by many central banks.
The EURJPY rally has no doubt been a green light for risk at the expense of US interest rates and Friday was no exception. When the ISM number hit EURJPY rallied nearly 1.5% in an hour. Year to date the EURJPY is up 11% while the THBJPY is up 10%, both outpacing the S&P 500 which is up 6.1% and high beta Russell 2000 up 7.3%. Currencies shouldn’t be moving like stock indices, and when they do, the reverberations can be felt in credit markets. The further JPY weakens the more US interest rates could rise.
US Bond Futures Weekly:
Still the biggest risk in the markets is that they lose confidence that the Fed can control interest rates in the long end of the curve, and the critical 143-00 pivot was an area where this thesis could play out. Last week was a frightening testament that when this market is ready to move there is little the Fed can do about it. At this point either this level holds and bond prices continue to rally back to old highs or it gives and the QE trade unravels in their face.
If bonds are topping, what kind of world would that look like? Despite the current optimism about stock prices that’s a question you don’t want answered.