Reversals

Doug Nolan

Commenting on Friday’s jump in global bond yields, a fund manager on Bloomberg Television downplayed the move: “Yields are back to where they were last week.” Such thinking badly misses the point.

Greed and Fear ensure that markets have an inherent tendency to “overshoot.” Over-liquefied markets can significantly overshoot on the upside. Markets for years dominated by ultra-low rates and massive central bank buying should be expected to overshoot in historic fashion. And that’s exactly what has unfolded. Major market Reversals tend to be violent and unpredictable affairs, catching almost everyone unprepared.

At the minimum, summer complacency ended rather abruptly Friday. Bloomberg: “Stocks, Bonds Spiral Lower Together in Replay of Past Hawk Raids.” Long-bond Treasury yields jumped 13 bps Friday, with a two-day surge of 20 bps (“biggest two-day rise since August 2015”). Ten-year Treasury yields rose seven bps this week to the highest level (1.67%) since June. German 10-year bund yields rose 13 bps (“biggest slide since March”) in two sessions to the first positive yield (0.01%) since July 15.

September 8 – Bloomberg (Kevin Buckland, Wes Goodman and Shigeki Nozawa): “One of the pillars of 2016’s record-setting global bond rally is starting to buckle. Japan’s sovereign debt is suffering its worst rout in 13 years, handing investors bigger losses over the past two months than any other government bonds amid speculation the Bank of Japan plans to change its asset-purchase strategy. The reversal is spurring concern the second-largest debt market is the vanguard for a broader selloff… The impact of the BOJ’s stimulus is that the bond markets worldwide are becoming one market,’ said Chotaro Morita, the chief rates strategist at… SMBC Nikko Securities Inc., one of the 21 primary dealers that trade directly with the central bank. ‘If there’s a reversal of policy, you can’t rule out that it would roil global debt."



The Bank of Japan is divided and wavering – an unsettling situation for Japanese and global bond markets. The BOJ is in the process of reviewing current stimulus measures, as it heads into a key September 20-21 policy meeting. After championing negative interest-rates, there is now recognition that prolonged negative rates and market yields have turned problematic for the banking system and pension complex. There is speculation that the BOJ may employ measures to steepen the yield curve, with all the uncertainty this latest policy gambit would entail.

Super Mario failed Thursday to allay market concerns. Restless markets were hoping that the ECB would commit to extending its QE program past the stipulated March ending date, while also expanding/tinkering with the mix of securities to be purchased (running short of bunds and other bonds to buy). Months pass by quickly. Seeking immediate assurances of “whatever it takes forever,” markets were left disappointed. Have Germany and the euro-area “hawks” been waiting patiently to reassert themselves?

Contentious central bank debates are not limited to the BOJ and ECB. Markets were hit with an untimely Friday morning “increasingly risky to delay U.S. rate hike” from none other than Fed dove Eric Rosengren. A spate of weaker data had moved sentiment away from expecting a September rate hike. Yet there is clearly an FOMC contingent that believes rates are too low considering the backdrop (M2 “money” supply up almost $900bn y-o-y; 4.9% stated unemployment rate; asset Bubbles, etc.).



History has demonstrated that, once commenced, monetary inflations are exceedingly difficult to control – let to alone rein in. Speculative markets have been keen to this powerful dynamic. 
 
Once the Bernanke Fed targeted inflating securities markets as the prevailing mechanism for post-Bubble reflationary measures, there would be no returning to conventional. The Fed talked “normalization” and “Exit Strategy” in 2011, only to double-down with massive stimulus after European-led market tumult erupted in 2012. Then there was Bernanke’s, the Fed will “push back against a tightening of financial conditions” that quashed the markets’ 2013 “taper tantrum.” Repeatedly the Fed shied away from even a little baby-step rate increase in response to unsettled global markets.

It was not much different in early-2016. After at long last initiating “lift off” in December, unstable global markets in January and February saw the Fed lose its nerve to follow through. 

Meanwhile, the BOJ, ECB, BOE and others adopted even more outlandish monetary stimulus. 

For good reason, markets fully embraced “whatever it takes for as long as it takes”. The latest monetary management iteration removed any potential QE limitation. Limits to negative rates were not yet close at hand. And if sovereign buying programs ran into constraints, central banks could simply shift their buying onslaughts to corporate bonds and equities.

Central bankers had fully embraced booming global securities markets. After years of aggressive support, they were all in. No turning back. Only a surge in consumer price inflation could possibly bring about a rethink of extreme monetary stimulus; and surely that wasn’t about to happen. For the markets: The sky was the limit.

As for global securities markets, the central bank-induced short squeeze morphed into an historic 2016 global market speculative melt-up. Caution was thrown to the wind - by central bankers, speculators, investment managers and investors alike.

After ending 2015 at an incredibly low 64 bps, German 10-year bund yields closed July 8th at negative 19 bps. Japanese JGB yields dropped from positive 26 bps to negative 29 bps. After beginning the year at negative 6 bps, Swiss yields fell all the way to negative 63 bps. UK yields collapsed from 1.96% to 52 bps (August 12). Spain’s 10-year yields sank from 1.77% to 0.92% and Italy’s from 1.59% to 1.04%. The U.S. Treasury long bond yield fell almost 100 bps from the end of 2015 to 2.06% in early July.

September 6 – Bloomberg (Brian Chappatta): “In the six months through July, about $114 billion flowed into 32 types of bond funds, ranging from developed- and emerging-market governments to high-yield corporate securities and municipal debt, according to… Morningstar Inc. The last time so much money poured into fixed-income was May 2013, right as the taper tantrum began.”



Global bond markets validated my maxim, “Bubbles go to unimaginable extremes – then double!” My view holds that this year’s bond trading has been dominated by historic market dislocation. As such, I presume that enormous amounts of leverage have accumulated throughout the global derivatives complex, as hedging strategies forced those on the wrong side of derivative trades to hedge in the cash market. As I’ve noted previously, the world’s largest derivatives market (interest-rate swaps) had to contend with previously unimaginable market moves.

It’s my view that this historic market dislocation unleashed a torrent of financial leverage and associated market liquidity. This liquidity tsunami spurred securities market inflation almost across the board. Heavily shorted securities, sectors, markets and asset classes benefited inordinately. Junk bonds enjoyed a huge rally, ensuring a major short squeeze for the stocks of scores of suspect companies (benefitting from a dramatic loosening in corporate Credit Availability).

Global short squeeze dynamics spurred a major rally throughout EM. The combination of outperformance and enticing relative yields then ensured “money” flooded into EM. The resulting EM debt issuance resurgence captivated the bullish imagination, reinforcing the rally in EM stocks, bonds and currencies.

Market “melt-ups” create their own liquidity. The extraordinary development this time around was that liquidity abundance turned systemic (combination of monetization and speculative leveraging). A short squeeze and resulting outperformance powered the risky stuff. Meanwhile, the historic collapse in sovereign yields poured gas on the speculative fire that had enveloped everything with a yield. The utilities, REITS, consumer staples and dividend stocks all made power moves. “Money” flooded into perceived low-risk yield plays. “Smart beta” became a slam dunk. Even better, boosting risk and leverage worked virtually everywhere. Caution and bearishness were punished mercilessly. Exuberance. All the classic signs of a major speculative “blow-off.” Even more “money” inundated equity index products.

And speaking of “blow-offs.” Few strategies benefited from the all-encompassing global liquidity deluge than so-called “risk parity.” A leveraged strategy comprising bonds, stocks and commodities proved golden. And it’s expecting a lot for managers to get worked up about stocks, bonds and various asset classes all turning highly correlated – not when “money” is being made hand over fist.

For many in the marketplace, Friday provided a major wakeup call. Stocks, bonds and commodities were all under pressure. Risk everywhere. Diversification suddenly nowhere to be found. Crowded Trades Galore. A few headlines: “Defense Trade Unravels as Bond Yields Jump Most in Month;” “Low-Volatility ETFs Are Anything But Amid S&P 500 Tumble;” and “Oil Tumbles Most in Month…”

Friday trading saw the Real Estate Investment Trusts (BBG REITS) sink 3.9%. The Dow Jones Utilities fell 3.8%. The previously outperforming broader market underperformed. The small cap Russell 2000 dropped 3.1% and the S&P400 Mid Cap index fell 2.9%. Transports slid 3.2%. Consumer Staples (XLP) dropped 2.7%.

No surprise if market tumult again holds the Fed – along with the BOJ - at bay. Yet that wouldn’t do much to resolve the serious dilemma now overhanging central banks and the markets. At this point, the global Bubble is sustained only through unrelenting massive central bank monetization (QE). Sustaining a late-stage, runaway speculative Bubble is risky, risky business. The inflated and detached securities prices become from reality the more outrageous the amount of monetary stimulus necessary to avoid collapse. QE has turned increasingly, hopelessly and fatefully destabilizing.

By now, global central bankers more clearly understand the trap to which they have fallen. 
 
Extreme monetary stimulus has suffered significant diminishing returns in the real economy, obvious to all. Yet negative rates and yields are severely distorting finance - the markets, banking systems and pension complexes in particular. Even to diehard proponents, the great monetary experiment has not worked as anticipated.

All along, markets have been comforted that when monetary stimulus (rates and QE) turns less effective, central banks have been conditioned to simply (and predictably) do more (negative rates, more QE, more equities and corporate debt). Mindlessly doing more and more is reckless – and not inconspicuously so. Perhaps the markets are beginning to fret that central bankers are weary of being held hostage, confused as to what to do next and alarmed by how things have unfolded. The downside of central bank market intervention and manipulation is that participants are today generally over-exposed, under-hedged and risk complacent/oblivious.
 
Fuel for Reversals.

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