There have been some scary moves in the bond markets … and no, for a change, we're not talking about Greece, Portugal or Spain. What's been happening since the spring on the benchmark, safe-haven curves is almost as worrying, says Martin Steward.
In mid-December last year, on this blog-spot, I suggested investors tempted to follow the recent sell-off in US Treasuries should "beware false trends". I observed that the US 10-year yield looked "oversold" based on its 200-day moving average, and I couldn't see any signs of inflation fears in the movement of breakeven rates.
Needless to say, I spent the next four months thinking, "Oh well, you can't win them all". Yields kept drifting upward, and the press and blogosphere started trumpeting that Bill Gross's PIMCO Total Return fund was "shorting US Treasuries" (it wasn't, strictly speaking - more on which later).
Then everything started to turn around through April.
At 10 years, US breakeven inflation peaked at 2.64% on 8 April, but has since fallen by 17% to sit at 2.21% today. The German market took a little longer to turn over: 10-year breakeven hit 2.45% on 4 May and is 2.02% today. But that move is peanuts next to the action we've seen at two years, where the US breakeven has plummeted 36% from 2.6% on 29 April to 1.67% today, and the German rate is down a whopping 55% from 2.36% on 4 April to 1.06% today. That takes us back to start-of-year levels in the US - and early autumn 2010 levels in Germany.
Breakeven rates are, of course, derived from both real and nominal yields, which at two years have essentially been exhibiting negative correlation for the past year - about -0.2 for the whole period and reaching extremes of -0.8 since the spring (I suppose this is a species of Gibson's paradox).
While 10-year real yields for both the US and Germany have been drifting down since February, at two years there has been a sharp sell-off: up 73 basis points to a (still negative) -1.29% in the US; and up 100bps to 0.40% in Germany. But nominal yields are down from April peaks - to the tune of 55% to 0.38% on the US curve at two years.
That seems important to me. Take Bill Gross's positioning. In conversation with Morningstar's Eric Jacobson recently, he spelled out that his fund had never been short US Treasuries. He was happy to make a relative-value argument: US Treasury yields are "very close to levels which don't seem to make much sense", so he would much prefer to be overweight "corporate bonds, mortgage bonds, other alternatives". But he insisted that "we've always been long Treasuries" and that the short positions that got reported were in swaps. The big bet Gross had made was to be short duration. "There haven't been very long maturities," he said. "In many cases, they've been six-month bills and one and two-year Treasuries." Even adding his other credit positions, his portfolio's duration has been "about a year shy" of the index average of 4.5 years - and those Treasury positions have underperformed the (overweight) "alternatives". Shortening duration "hasn't been exactly a great call", said Gross - but it wasn't a short-Treasuries call.
Gross certainly was not alone in shortening portfolio duration. I've lost count of the number of times I've read bond managers reminding us that "the only way is up" for interest rates. Selling inflation-linked bonds is a great way to shorten duration - but it seems clear that that is not what is motivating the sellers at the moment. If duration was what you thought you were selling when you dumped TIPS, then presumably you'd be dumping nominal bonds, too, and we would not have seen that big pick-up in negative correlation between real and nominal yields. Moreover, after steepening sharply during Q4 2010, both the US and German nominal curves have been flattening more or less gently since. And remember, this is despite the spectre of the end of QE2 hanging over the markets - in fact, the turnaround in real yields seemed to follow the US Federal Reserve's hints in March and April that the programme would be coming to an end.
All of which must surely lead us to recognise that what we have seen since the spring is a genuine disinflation - or even deflation - trade. JPMorgan Asset Management recently made the argument that "government bonds look overvalued" by generating theoretical yields that were the sum of inflation expectations and their own forecasts for real GDP growth. Real GDP growth in the US of 3% suggested that 10-year Treasuries should be yielding 5.2%; real GDP growth of 1.95% in Germany suggested a 10-year yield of 3.85%.
But, of course, one could turn that equation around by assuming that the bond markets are right rather than JPMorgan's growth forecasts: in that case, one arrives at US real growth of 0.75% and German real growth of 0.95%.
Recent data have indeed been horrible: US Q1 GDP growth clocked in at 1.8% annualised, down from 3.1% during Q4 2010, and the Q2 projections don't look great, either; the jobs situation increasingly points to a broken US labour market; recent PMI, consumer spending and consumer sentiment numbers have been distinctly soft; estimates of US M3 growth come in at around 3% year-on-year, 2 percentage points lower than the long-term trend despite the Fed expanding its balance sheet; and US house prices continue to trickle downward.
The US Treasury reported rising demand for US assets in April, and there are still an awful lot of savings to be recycled into euro and dollar-denominated bonds. Even if the Fed calls an end to quantitative easing this month, it will still go on re-investing coupons. Investors may continue to see the Fed's withdrawal as a 'risk-off' signal and the US yields as the only 'safe haven'. And, looking beyond the immediate withdrawal, it does not seem entirely crazy to suggest bond market action since the spring could represent some anticipation that a lengthening 'soft patch' in the global economy could eventually be met with a QE3.
In short, it's surprisingly easy to find reasons why benchmark yields should continue to trundle along at their current 'depressed' levels. Who is brave enough to bet against it? Well, there's Bill Gross, for one. To re-visit and fill-out an earlier quote: "[T]he United States economy [may be] going the way of Japan, and perhaps there are more capital gains to be had, but we're very close to levels which don't seem to make much sense."
Japan is, of course, the shadow looming over this blog. It may be the shadow looming over the bond markets. It may also explain the hyper-Keynesianism of Gross's latest 'Investment Outlook', published today. "Ricardo and his 'equivalence' belong in the trash bin," he writes. Anyone who believes the private sector will come through with short-term job creation in the US is "crazed" and needs to ask why so much cash is being hoarded on corporate balance sheets. The US "needs to learn from [China's] state-oriented model" and "have a shovel in the hands of the long-term unemployed from 8am to noon, and from 1pm to 5pm […] have them studying algebra, physics and geometry".
That may be the prescription the US - indeed the Western - economy needs. It would certainly be one way to get US yields moving in the direction he wants.