What a true bond bear market looks like
A couple of years ago I remember having a discussion with a hedge fund manager. I told him about my theory that the next big surprise would be higher bond rates, not the other way round. I distinctly remember him lecturing me about the overwhelming forces of demographics, technology and globalization. All of these added up to deflation – not inflation. I couldn’t convince him that when everyone agrees on something, it’s time to expect something different. We agreed to disagree.
Today, the tables have completely turned. It’s now fashionable to be a bond bear. So much so, I probably don’t need to repeat the common bond negative narrative that has spread through the financial community faster than chlamydia at a Banff youth hostel.
To see the preponderance of negative bond sentiment, all one has to do is look at the speculative positioning in the fixed income futures market. One of the easiest ways to hedge against higher interest rates is the CME 3-month Eurodollar contract. This contract has nothing to do with the euro currency, but instead represents the rate at which banks lend US dollars to one another overseas. Speculators are so confident about higher rates that they are short almost $4 trillion ED futures.
That’s a mind bogglingly large position.
And it’s not confined to eurodollar futures. The US 5-year treasury future is also stuffed full of speculative short positions.
The anecdotal evidence is also adding up. Market legends are appearing all over the newswire – warning about fixed income.
“With rates so low, you can’t trust asset prices today. And if you can’t tell by now, I would steer very clear of bonds,” Paul Tudor Jones at a recent Goldman event.
It’s easy to see why these pros are so bearish. The tape looks like crap.
You might notice that I have been focusing on the front end of the yield curve. That’s on purpose.
Not all parts of the curve are the same
During the next part of this post, it might appear I am making contradictory arguments, but it’s important to note that different parts of the yield curve react in different ways. It’s not as easy as just saying you are bearish on bonds and then shorting TLT. It’s much more nuanced, and without understanding all the dynamics in play, you might find yourself right about your call, but not making any money.
Anyway, here it goes – the statement most likely no one will like. The short end of the yield curve is oversold, while the long end has not even started to understand what a true bond bear market looks like.
Huh? What do I mean by that? Well, I think the front end of the curve is overly optimistic about the Fed’s ability to keep hiking, while the long end of the curve is way too sanguine about the Fed’s skill in controlling inflation.
So far, most market participants have assumed that Central Banks will keep inflation under wraps. As economic indicators have continued to tick higher, markets have pushed yields up at the front end of the curve. This has traditionally been the playbook. Economy does better. Market rates rise. Fed follows curve higher by raising Fed funds rate. This continues until rates rise enough that the Fed inverts the yield curve and the economy rolls over. Then the Fed slashes rates and the whole process repeats.
