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Thursday, March 28, 2024

The Rats Are Fleeing The Sinking Bond Ships

Courtesy of ZeroHedge. View original post here.

Glen Hubbard, George Bush Jr.’s economic adviser, was a candidate


to replace Alan Greenspan as Federal Reserve Chairman.  George Bush Jr. asked him if the economy


sputtered, what would he do.  As he


described the typical monetary policy tool of adjusting the overnight Federal


Funds Rate, he said the net result would be to boost GDP by a half of a percent


to percent.  I assume the same question


was asked to Ben Bernanke.  Helicopter


Ben didn’t disappoint and won the appointment.  As Chairman of the Federal Reserve, he got his


chance and threw everything including the kitchen sink at stimulating the


economy.  He lowered the Federal Funds


rate down to zero and purchased trillions of bonds to expand the monetary base.


 He unleashed the most excessively


accommodative monetary policy in history which was continued by current Federal


Reserve Chairman Janet Yellen.  Fast


forward to today and we are on the cusp of a 3+% GDP, core inflation running


above 2% and full employment.  However,


there are some perilous costs associated with such accommodative monetary


policy.  The cost that should be the most


worrying is the unwinding of the ultra-low bond yields in the US and globally


that has just begun.

Bond yields and market volatility are on the rise. This is


the result of more normalized growth and inflation levels, less perceived


global risks and hope for continued growth in the future. Fixed income investors


have just begun to adjust to the idea of more normal yields in the bond market.  It may seem tempting to dip a toe into the


bond market waters with this back-up in yields. But these are dangerous waters.


Don’t lose a toe.  After 10 years of bond


markets rallying the unwind is just beginning.

Normalized markets for longer dated government bonds places


yields around 2% to 3% above the rate of inflation.  And with inflation running at 2% and moving


higher, longer term bond yields should be greater than 5%, not the current 3%.  If bonds yields backed up to the longer term


averages, market losses could be 40% or more for the longest maturity bonds.

The trillions in bond purchases that drove yields to


all-time lows have abated and that’s bad news for bonds.  Banks have finished adding regulatory bond


purchases and central banks have ended or are close to ending bond purchases


for monetary policy purposes.  Government


bond purchases made to limit rising currencies have now turned into sales to


limit currency weakness.  And oil


producing nations are no longer looking to put their surplus dollars from oil


sales to work in the bond market.  They


are now selling bonds to fund the holes in their fiscal budgets stemming from


low oil prices.

The last big purchaser of bonds still remains some very


large and leveraged hedge funds.  Hedge


funds have been caught on the wrong side of the global bond trade and are now


trying to avoid selling their positions.  Fear and greed had helped keep bond yields at


these low levels for longer than most would have thought.  In fact, yields have been so low for so long,


anyone betting on higher yields has been fired, put out of business, or


probably has a laundry list of stress related health problems.

Whatever backup in yields we’ve seen, it’s just the first


movement it what is sure to be an unharmonious symphony.  The bond market has spent years below more


normal long-term yields while unprecedented accommodation was stuffed in the


system. It is highly probable and reasonable to believe that the bond market needs


to spend some time above the long run yield level.  That, by definition, is how an average is


created.

Now that the fixed income market has begun to adjust, losses


are piling up and will soon be reported to investors.  The size of these losses are sure to shock the


investor community that has grown accustomed

to steady gains from fixed income.  In fact, when people open up their monthly account


statements and see excessive losses from bonds yielding low single digits, the


second movement in this symphony will begin.  Disappointed bond investors will soon put in


sell requests and leveraged bond managers who were the last marginal buyer of


bonds will have to turn into sellers. 


Market yields will have to adjust higher and find a level that attracts


the unlevered bond purchaser.  And that


yield level appears to be much higher.

So what is an investor to do?  Many hedge funds are trying to hold off


liquidating bond trades by offering fee rebates to limit redemptions.  This is always a leading indicator of more


pain to come. Just like rats that leave a sinking ship before it goes under,


redemptions are starting to line up at many bond hedge funds.  These hedge fund captains are offering cheese by


reducing fees which is sure to entice the fat rats. After 10 years of easy


money in the bond market, these fat rats are incapable of swimming and will


choose the cheese.   I remember when the over leveraged Long Term


Capital Management hedge fund first started to suffer losses in their bond


portfolio.  They incorrectly believed


that if needed, more investor capital would be available to stabilize losing


trades.  My advice to investors is to


take a lesson from history and don’t bet on this old proverbial dead cat


bouncing.  When markets turn, it’s best


to move back to cash and let the markets readjust.  After such a long period of low yields and


limited volatility, this market symphony will have many movements and we are


not even at intermission.

    

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