“Fire” in the Bond Market – Fed Raising Rates and US Issuing Ultra Long Bonds – by Michael Carino

The bond market is on fire and you are about to get
burned!!!  Bond yields are lower and interest
spreads as tight or tighter than that of the bond market crisis of 2008.  This will lead to a catastrophic financial
train wreck that can happen at any moment. 
Why do I feel like I’m the only one sounding the alarms?  Where is the media to help warn and prepare
the marketplace?  Why are investors going
along and playing in what seems to be a rigged and tragically destructive game?
 It reminds me of the story of a frog
jumping into a boiling pot of water. Once the frog hits the hot water, it jumps
right out.  But the frogs that is in the
pot when the water starts out cold slowly gets cooked.  The Fed has excessively accommodated financial
markets for almost a decade. This has been such a long, accommodative cycle,
investors can’t tell how close they are to getting cooked.

Some of the world’s largest and most sophisticated investors
who pride themselves on being some of the smartest individuals are taking some
of the most expensive risks with the worst payoff profiles of all time.  Obviously, most investors have short term
memories.  Longer-term government bonds
typically trade above the level of inflation by 2-3%. That should put the long
bond around 5-6%. However, when there is an asymmetric skew in the economic
data, like there is today, where growth and inflation has a higher probability
to surprise to the upside, the premium should be even higher.  Longer-term US Treasuries now yield 2-2.8%.  If the longest US Treasuries normalize, the market
losses could be as high as 50%!

Over the last couple of weeks, long dated US Treasuries
rallied 40 basis points. That may not seem like much, but this is days before
the Fed is going to raise rates another 25 bps.  What makes this move absurd is that the rally
happened not when rates are normal, but still priced for a recession or a
depression.  When factoring this 25 bp
hike in short term rates, that is a 65 bp compression in spreads – a huge move!
Why?  Was there a natural disaster?  Was there a financial catastrophe?  Both of these might be justification for a 25
or 30 bp spread tightening. But 65 bps? 65 bps is over 20% of the US Treasury long
bond yield!

What has come out over the last couple of weeks is that GDP
is running around 3%, CPI and PPI – core and headline inflation are running 2%,
the unemployment is at a cycle low of 4.3% and the Fed is hiking rates and going
to reduce their balance sheet.  This is
an environment where overpriced bonds should be getting decimated because current
yield levels are so low.  It is clear
that fundamentals have nothing to do with setting yields in the bond
market.  What has been setting yields is a
consortium of Treasury market investors that have been high volume trading
Treasuries aggressively during typically low volume periods and making the
market believe – through price action – that there is great demand for bonds.
This is nothing more than squeezing the bond market and giving it misinformation
in hopes of bluffing bond investors to not pull the ripcord and cash out of the
bond market. 

This is not a unique strategy.  This is the same strategy employed during 2006
and 2007 to coax longer term bonds into a low volatility state.  This flattened the yield curve with declining
long term yields as the Fed raised Fed Funds from the historically low 1% last
cycle.  And what did that lead to?  This high volume, volatility diminishing
trading of long term rates led to mispricing of all risks embedded in the bond
markets.  And when those risks eventually
were realized (when Fed Funds raised high enough to be a substitute for
overvalued bonds), the normalization process was rapid.  This market move confused investors that were
clueless as to what was setting yield levels before, during and after the
crisis.  The financial crisis of 2008 was
only a crisis because yields were mispriced too low due to the manipulation in
the Treasury market.  If rates were
normalized in 2008, there would have never been a crisis.  Yields and spreads would have only moved a
little bit higher instead of having to adjust so drastically that anyone with
leverage or a low risk tolerance was forced to sell.  This led to a lack of liquidity in the bond
market and the Fed having to step in to provide liquidity.  The Feds mistake is they provided the
liquidity then and still are today.  This
encourages reckless risk taking in the bond market and the insanity continues
today. 

To make this last paragraph a little clearer, monetary
policy in the last cycle was over accommodative. These conditions led to the
2008 financial crisis.  The Fed’s
response was to be even more accommodative for an even longer period of time.
They expect different results this time? (Definition of insanity!)  I fear with this next crisis congress will
place the blame squarely on the Fed.  The
result, most likely, will be a different mandate for the Fed – if the Fed
continues to exist at all.  But I
digress.

The Fed will raise interest rates in two days.  The US Treasury Secretary Mnuchin just repeated
he is looking into issuing ultra-long bonds (great timing).  The job market is tight and global economy
roaring.  In the US, you can’t find a
parking spot and homes are selling over asking price again.  This is not the recessionary or depressionary
conditions reflected in the bond market.

Congratulations to the Fed.  They saved us from the last financial crisis
by sowing the seeds of the next, never to be out done, even more spectacular
financial crisis.  The Fed has
manipulated the markets by buying 5 Trillion of bonds and a consortium of bond
investors are manipulating the markets, trading 1 trillion of government bonds in
the cash and futures markets daily.  If
you think fundamentals are setting prices in the bond market, your wrong.  Let’s be clear: when fundamentals matter in
the market place, yields and yield spreads will be double to triple of what
they are today.  So get ready to hop out
of the financial pot before the water gets too hot.  With the Fed hiking rates and reducing their
balance sheet and the bond market grossly overvalued, the pot may start to boil
faster than most expect.

by Michael Carino, 6/13/17

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?