It’s Bull Market in Bonds…The US bond market has hugely out-performed the stock market this year…up ~16%…while the DJIA is flat and the S+P is up ~5%. (Last year was a different story…the DJIA rallied ~22%, the S+P ~28%…and the long bond fell ~15%.)
It’s an even Bigger Bull Market in European Gov’t bonds…yields in many countries have fallen to historic lows…Spanish 10 year Gov’t Bonds have the same (2.3%) yield as US bonds…10 year German Bunds yield less than 1%…2 year Bunds have a NEGATIVE yield.
Historically the bond market has been considered “smarter” than the stock market…so, why the BIG rally in bonds? (Remember last year…everybody was predicting that interest rates would be going up?…well, it’s been 8 years…and counting… since the Fed last raised interest rates.)
Is the bond market up on deflation worries? Yes. Is it up on Geo-political stress? Yes. Geo-political stress is deflationary.
But let’s be clear…this is not your father’s bond market. As David Rosenberg explains, nearly 90% of all US Treasuries issued over the past couple of years have been bought by the Fed, the BOJ and the PBOC. The traditional buyers (insurance companies, mutual funds, pension funds, retirees etc.) are left with “crumbs.” So the signals we get from the bond market are not as valuable as they might have been “back in your father’s day.”
In fact…in the context of “be careful what you ask for”…Central Bank buying may have destroyed a very valuable source of economic intel…the bond market “vigilantes” might have demanded higher interest rates from profligate governments…but under current circumstances…and isn’t it ironic…as countries go deeper and deeper into debt their “cost of funds” keeps falling!
European Deflation:
Several European countries (excluding the UK) are in deflation…with no growth and high unemployment…and now even Germany is sliding into recession…the Euro acts as a strait-jacket and the ECB isn’t helping. Bonds issued by the peripheral countries have had a huge rally…buyers must be assuming that the ECB will finally buy Sovereign bonds in an attempt to stimulate the Eurozone economies…why else would anyone buy Spanish bonds with same yields as US Treasuries…if they didn’t think that they could unload them (to the greatest fool of all!)…or maybe the buyers simply think that the Eurozone is on the same sort of deflationary path that Japan took…2 decades of deflation…and TINY bond yields…
The weakness of the Eurozone economy leaves it very vulnerable to a shock…the sanctions on Russia…and counter-sanctions…the current escalation of geo-political stress from Russia/Ukraine may be the trigger to dump the whole Eurozone economy into deflation….and since the Eurozone represents ~20% of the global economy we have…
Sputtering global growth:
In July the market began to “price in” a rise in interest rates by early next year….but since the end of July there’s been a sharp reversal in sentiment…the consensus view now seems to be that the Fed will move very slowly.
Despite trillions of dollars-worth of stimulus from the world’s central banks…global economic growth is sputtering….but…
America looks relatively better than the Rest of The World:
Employment is stronger…energy is domestically available…it’s a “safe harbor” in times of stress…the Fed is likely to tighten before other Central banks…
Canada is next door to the USA and may benefit from that to some degree in terms of global capital flows…but given that we expect the US Dollar to rise, as capital (seeking safety and opportunity) flows to America…we see CAD lower against the USD especially because:
Commodity prices are under pressure:
The CRB Index has fallen ~10% in 6 weeks…it’s very close to breaking a 4 year old support level. The commodity market had a great run from 2001 to 2011…while the US Dollar was weak…but now with sputtering global growth commodities are under pressure…any evidence of slowing Chinese demand would be deadly for commodity prices…and weak commodity markets mean weak commodity currencies (CAD, AUD, NZD.) And speaking of currencies…we expect more…
Currency wars:
Cash-strapped governments hoping to remain in office will be very tempted to devalue their currencies…this same temptation may lead to the breakup of the Euro as peripheral countries (let’s put Italy at the top of the list…thank you, Ambrose) seek salvation via a weaker currency. We foresee the very real possibility of intensifying geo-political stress…intensifying deflationary pressures…and intensifying currency wars…in a vicious circle.
Trading:
We remain long the US Dollar index as a core position. The index is heavily weighted with European currencies and we expect them to weaken into year-end.
We captured the equivalent of 600 Dow points on the late-July/early August break in the stock market…we’ve been on the sidelines waiting for the bounce off the August 14 lows to run out of steam…if the market rolls over we will get short again…looking for a break to take out the August lows…BUT…we have to respect the momentum in this market…it could easily rally to new All Time Highs.
We’ve written OTM calls on CAD and AUD and will look to get outright short these markets (and NZD) as we expect they will break this year’s lows.
Gold has been very choppy…due to a combination of “chunky” trading and swirling geo-political stress…we think gold could fall in a strong USD environment (and as leverage is wrung out of the markets) but it could also easily spike on a geo-political “flash”…so…we have no position at the moment.
It was interesting to see both bonds and stocks rally this past week. If bonds were “desperately seeking safety”…why did stocks rally? Maybe both markets think that deflationary pressures are so strong that central banks (at least the ECB) will be forced to crank up the printing press…for nearly 2 years we’ve maintained that the last BIG leg up in the stock market began in November 2012 with the realization that Abe was going to win the election and push the BOJ to print money BIG TIME…well, imagine what a boost the ECB could give the stock market if they decide to “crank it up”…and remember that the Yen took a huge fall when the BOJ began printing…well, imagine what could happen to the Euro…
Longer Term Perspective:
The Big Break in the bond market last year brought prices down to the 35 year up-trend line…and they’ve bounced nicely from there…perhaps the long-term rally from Paul Volker’s 1981 lows has just begun another leg higher?
