After 10 years of manipulating the bond market, the Federal Reserve has overstayed its monetary policy welcome and created systemic conditions that will have high costs for everyone. There is a place for depressionary and recessionary monetary policies, but that was almost a decade ago. With GDP approaching 3% and inflation running above 2%, do we really need policies and statements that keep unwitting investors in a perpetual state of fear reflected in bond market yields that are usually reserved for severe recessions and depressions?
There is no question that this hyperactive Fed knows how to throw every monetary policy tool at economic problems stemming from a dysfunctional government that creates poor polarized policies. Yes, the Fed feels compelled to correct these politically driven negative impacts and in the process subsidize and fund them.
Political and egotistical reasons have limited the Fed’s reversal of such policies. The Fed knows the catastrophic financial impact of reversing a decade of market manipulation in the bond market. Bond yields are lower and prices higher than the overpriced conditions of 2006-2007 that lead to the 2008 bond market crisis. If conditions are worse now than then, need I say more on market embedded risk due to mispricing? But the Fed knew the conditions in 2006 and 2007 as well. That is why they went on a 25bp rate rise campaign on their last tightening cycle. They feared excessive volatility would lead to a quick repricing in the bond market and the uncertain economic and market reactions.
Wash, rinse and repeat. The Fed has followed the exact play book – and yes, you should expect the same results. However, investors do not have to come along for the same ride. They can open their eyes and acknowledge what is going on. A decade seems like a long time ago. The Fed is hoping short memories and the annihilation of any trader that focuses on value in the bond market can assist in the slow unwind of this mispricing. But just like the 2006-2007 period, the slow unwind didn’t lead to an unwind of the mispricing. Instead, it led to the addition of risk to make up for lower net income and higher funding costs.
Today’s bond market reflects an eerily similar environment. As short term rates are adjusted higher on a slow, highly expected path, traders and significantly invested participants are squeezing the market through various techniques and bond prices are not adjusting lower. With the Fed trying to keep volatility out of the bond market, it creates an environment for oligopolistic bond investors to limit losses through various manipulative and market squeezing strategies.
Higher short term rates leave limited to no yield differential to compensate for the risks embedded in longer term bonds. Some argue as the Fed raises rates, longer term bonds should outperform due to a restrictive Fed. Wrong! If the Fed was to have a restrictive policy, then yes, long term bonds should outperform and be priced for a restrictive policy. But first and foremost, Fed policy will not be restrictive until they unwind their balance sheet of over 4 trillion. Every trillion they own can be estimated up to 1% of easing. So rates should be 4% just to have a neutral impact on monetary policy. Ignoring this minor impact, Fed policy is not considered restrictive until the Fed Funds rate is 1% to 2% above the level of inflation – currently running around 2.5%. So if Fed Funds were 4% to 6%, and longer term bond yields 1% to 2% higher for an adequate risk premium, yes, you could argue the bond market should be flattening – or longer term bonds outperforming.
Unfortunately, longer term bonds yield 2% to 2.5%. This is why the current mispricing is so potentially devastating. Not only is the Fed raising rates, but they are going to shrink its balance sheet as government bond issuance is expected to surge. The Fed has manipulated long term rates lower by focusing on longer term bonds and removing duration from the market place. The government as well is looking at issuing long term bonds, or add duration to the market place. The point is just like 2006-2007, the risks continue to build in the market place, but prices and yields have not adjusted. The crisis of 2008 would not have been a crisis if yields reflected reality and were high enough to justify the risk embedded in the market place. The same is true today. Too much risk embedded in a market place with not even close to enough yield to offset it. With a nod and a wink, the Fed helped manipulate rates by saying they will keep rates lower for longer. The large investors took this and ran. Some of these investors now have hundreds of billions stuck at low yields in the bond market. They can’t ever get out of these positions without hurting themselves through much higher yields. Instead, they bide time manipulating rates when they can, hoping for headlines or the next recession to contain the eventual pain or a repricing.
And the manipulation is glaring. Going into the July Treasury auctions, it was apparent there is limited appetite for purchasing bonds at these prices. Yields have been rising as auctions get closer. The last auction, the long bond rose to 3.05% yield to attract enough buyers. But once the supply is out, those that had to buy it use high volume trading tactics during low volume periods to pop the prices of bonds back up. Within days, these traders were able to reprice a 3.05% yielding auction down to 2.86%. Make sense? No. But this is where risk comes from. Those that have mammoth bond positions that are cemented in will pursue whatever strategy necessary, squeezing out those with opposing views to maintain current yield levels. How did that work for the Hunt brothers in the oil market?
Nothing holds a mispriced market together better than a diminishment of volatility. Higher volatility makes it visibly clear to all that there is too much risk for not enough yield. There is an asymmetric skew in current economic data (topic of the next article) where growth, jobs and inflation are all at the higher end of the range, yet bonds are still priced as if in a recession or worse. Current employment based statistics and antidotal information forecasts the payroll report should have been a monster number. Sure, the BLS has a knack to diminish volatility in this number by coming out with one number then months later having significant revisions. They justify this by taking a symmetric approach to their volatility diminishing adjustments. At 138k, this number shows a healthy economy and jobs market before revisions. However, I believe the strength of the jobs market make this number likely to be eye popping upon revisions. As bond market prices reflect a recession, the unemployment rate just dropped down to a seldom seen and envied 4.3%!!!
As a few very large balance sheets continue to trade and support the bond market focused on minutiae such as the latest Trump tweet or other tertiary information, don’t forget the variables in front of us all. The economic environment is healthy and normal with a chance of running too hot, the bond market is still priced for a recession and they Fed is slowly taking the punch bowl away from the greatest party of all time.
by Michael Carino, 6/2/17
Michael Carino is the CEO of Greenwich Endeavors, a financial service firm, and has been a fund manager and owner for more than 20 years. He has positions that benefit from a normalized bond market and higher yields. Do you?
