I had another topic planned for this week's column, but then North Korea had to go and conduct an underground nuclear test -- literally and figuratively. I'm concerned about the ramifications of that test in general, but what concerns me more specifically about that test is the reaction of sovereign bond markets to it.
Basically, there was no reaction to it.
Here we have a rogue nation, with a nutty leader, getting one step closer to being able to deploy a nuclear weapon and what did sovereign bond markets do? They sold off. There was no flight-to-safety in the sovereign bond markets. Zero. Nada. Zilch. The yield on the 10-yr Treasury note rose eight basis points to 1.67%; the yield on the German bund jumped seven basis points to 0.01%; the yield on the UK gilt climbed ten basis points to 0.76%; and the yield on the Japanese government bond increased two basis points to -0.03%.
Separately, China reported on Friday that its consumer price index was up 1.3% year-over-year in August, versus 1.8% in July, and Germany reported a decline in both imports and exports for July.
That is bond-friendly stuff, yet bonds came under enemy fire anyway. Today, we'll examine why -- or at least why we think they did.
Four on the Floor
Our suspicions boil down to four factors.
1) The bomb dropped by the European Central Bank (ECB) on Thursday
At its Governing Council meeting this past week, the ECB did nothing, leaving both its interest rate complex and its asset purchase program unchanged from July. In fact, the Governing Council didn't even talk about extending the asset purchase program at the latest meeting, according to ECB President Draghi.
These were bombs for the bond market in the sense that many participants were primed for the ECB to do something -- anything that provided an extra dose of stimulus. The takeaway for some in the reticence to expand the scope of its bond buying program and to lengthen the specific end date was that the ECB recognizes quantitative easing is nearing its limits as a tool for spurring a pickup in inflation. That thought created some added jitters that the Bank of Japan, which meets September 20-21, might have a similar revelation.
While those views are certainly debatable, the notion that bond yields in domestic markets will be rising, if the ECB and Bank of Japan no longer find it practical to increase the size of their bond buying programs, triggered a shock wave of selling in sovereign bond markets.
In turn, there were related concerns that the ECB deciding to do nothing was a tacit shot across the bow at fiscal authorities to do something.
Fiscal stimulus is seen by some as the next great hope for boosting economic growth, yet such plans could come at a higher price given already bloated debt-to-GDP levels for many countries that could invite higher borrowing costs with new fiscal stimulus plans.
2) The shots fired by influential bond fund manager Jeffrey Gundlach
Mr. Gundlach runs the $62 billion DoubleLine Total Return Bond Fund (DBLTX), which has a five-star rating at Morningstar. He made waves a few months ago when he said his firm went "maximum negative" on Treasurys on July 6 on account of risk-reward being horrific at the time.
That has turned out to be a pretty good move so far. The price of the 10-yr note has gone down 3.9%, and its yield has risen 30 basis points to 1.67%, since July 6. In an investor webcast after the market closed on Thursday, Mr. Gundlach said it is time to get defensive on bonds, which he believes are sniffing out longer-term inflation risk that will drive a secular shift in monetary policy (i.e. Fed rate hikes).
Strikingly, the long end of the Treasury curve, which is more sensitive to inflation pressures, bore the brunt of Friday's selling interest. The front end was less responsive, but probably only because investors were thinking the upset in the bond market, which upset the equity market, would at least prevent a rate hike at the Federal Reserve's September 20-21 meeting.
If you think that contradicts Mr. Gundlach's thinking, we can understand why. Even so, Mr. Gundlach has enough credibility as a bond fund manager that his views resonate, particularly when his last call was spot on.
3) The views of FOMC voters
There are ten voting members on the FOMC this year and two committee members spoke on Friday -- Fed Governor Tarullo and Boston Fed President Rosengren. Neither man left the impression that the Fed will wait to raise rates until sometime next year. In a CNBC interview, Mr. Tarullo said he wouldn't "...foreclose the possibility of a rate hike this year." Mr. Rosengren, meanwhile, gave a speech to the South Shore Chamber of Commerce in Quincy, Massachusetts. In that speech, he said, "My personal view, based on the data that we have received to date, is that a reasonable case can be made for continuing to pursue gradual normalization of monetary policy."
Mr. Rosengren clearly didn't say that he thinks another step on the path to normalization should be taken in September; nonetheless, his insight was bothersome to the bond market because he didn't dismiss such a notion and because he holds this view after the weaker-than-expected employment report for August and the much weaker-than-expected ISM Manufacturing and Non-Manufacturing Surveys for August.
The fed funds futures market still isn't buying the argument for a rate hike in September. The CME's FedWatch Tool shows only a 24% probability of a rate hike in September, although that is up from 18% on Thursday.
There has been enough chatter, though, from other Fed officials about the case strengthening for another rate hike that it has left the capital markets on edge about the possibility the Fed could surprise a lot of people with a rate hike later this month.
4) The lack of a flight to safety or a flight to bonds, generally speaking, despite supportive headline catalysts
As noted above, there were a number of headline catalysts that supported bond buying. That buying didn't materialize, however, and when it didn't, it got plenty of people thinking that perhaps Mr. Gundlach is right about getting defensive on bonds. If nothing else, the lack of buying in the face of supportive headlines certainly made holders of government bonds more aware of the concentration risk in the market, which stems from an ingrained belief that long-term rates won't spike because of central bank action, interest rate differentials, demographic patterns, and pension fund buying to name a few dynamic forces.
Essentially, the age-old paradigm of risk-reward seeped into the consciousness of market participants. Is there more risk in buying government bonds today or more reward? It would seem that many saw more risk on Friday. We'll let readers decide for themselves, but we'll offer the chart below as food for thought.
What It All Means
In my column from three weeks ago, Cracking Open a Six-Pack, I identified six factors that I felt could be a potential spoiler for the bull market (in equities that is). The first factor I listed was a spike in interest rates. What I said then was this: The stock market has feasted on the persistence of low, and declining interest rates. They have forestalled valuation concerns for many and have fueled a run into higher-yielding equity securities and higher-yielding fixed income products where price risk has been overlooked in the pursuit of income generation.
A spike in long-term rates would be a destabilizing factor, primarily because it is not expected, but also because it undermines the bid to seek yield outside the Treasury market and the complacency surrounding stretched valuations.
Several weeks before that column, I wrote a piece entitled From Seeking Yield to Seeking Profits. In that column, I discussed the concentration risk surrounding the high-yielding areas of the stock market. What I said then was this:
Bond rates have come down sharply while high dividend yielders have gone up sharply. Those respective moves are correlated with the former driving the latter. It doesn't take much to imagine, then, what could happen to the stock prices of high dividend yielders if bond rates jumped noticeably from their currently depressed levels.
It is concentration risk at its finest and it is a risk investors may want to mitigate by taking some money off the table in stocks that have been driven up a lot less by fundamentals and a lot more by efforts to seek higher yields.
Wrapped up in the concentration risk is price risk for many of these stocks, which will be rolled back if the group think turns in the other direction.
The manner in which sovereign bond markets traded on Friday was unsettling from the standpoint that it was the type of response that suggests a key inflection point has been reached. At the least, it served notice how rising interest rates can unsettle the stock market -- and bear in mind that we're talking about a 10-yr note still yielding less than 1.70%.
The stock market can tolerate interest rates that go up for the right reasons and at a steady pace, but when rates go up when they should go down, and they go up quickly, it becomes a more nettlesome factor.
If you want to know why the stock market and many of those favorite "seeking yield" plays behaved so poorly on Friday, look no further than the sovereign bond markets, which got bombed by a turn in sentiment.
Patrick J. O’Hare, Briefing.com
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2016-28016 Exp 8/2018