Over the last two months, the Fed has tried to continue to communicate
that they plan on raising rates up to at least 3% and reduce their balance
sheet by trillions. They just raised the
Fed Funds rate by 25 bps to 1.25%. However, long term rates rallied by 50 bps! And the
short end of the interest rate curve is priced with yields on top of the Fed
Funds rate. This implies that either the
Fed is lying and does not plan to raise rates again (or even lower rates), or
something is broken in the bond market.
After a decade of manipulation in rates by central banks
globally, bond markets are priced at some of the richest conditions ever. There could not be a greater disconnect with
actual economic conditions. Globally,
there is no crisis on the horizon and sovereign risks could not be lower. GDP is tracking close to above average 3% and
inflation right on 2%. Spare capacity
near or at a cycle low, increasing the probability that inflation is going to
run too hot going forward.
So why did long term rates recently rally 50 bps? Such a large move surely comes on the heels of
a financial crisis or recession. No,
this move comes from the excessive conditions built over the last decade in the
bond market. When such extremely
disconnected conditions exist, the probability of a financial crisis from an
unwind of these conditions is extremely high. The latest move to lower rates, even as the
Fed is trying to normalize rates is due to the manipulation of bond markets by
a consortium of large balance sheets that trade Treasuries in high volume
during low volume periods. This is the
strategy pursued in 2006 and 2007 and led to flattening of yield curve and
diminished volatility as Fed raised rates.
These high volume strategies take advantage of a soft Fed that
telegraphs every step and stretches out their policy moves over long periods of
time. This leads to high volume
strategies believing the Fed issued a put on rates and therefore excessive
risks can be taken to profit in the short run.
Mohamed A. El-Erian, bond market veteran and specialist
wrote today that the Fed should continue to raise rates “and that policy makers
should take seriously the growing risk of future financial instability,
especially in the absence of a carful normalization”. Other Fed officials, including the Fed’s vice
chairman, William Dudley has also been sounding the alarms of a bond market out
of control and resulting future financial instability. The bond market has turned into a game of no
limit poker played by the biggest balance sheets and finally the alarm bells
are getting rung.
When the Fed tightens, rates usually rise as markets prepare
and adjust for the tightening cycle and resulting risks. Real rates can adjust to over 300 bps. Real rates today are close to 0%. Unlevered bond market losses can hit a
staggering 50% if rates normalize.
When rates are more normalized and the Fed raises rates, the
yield curve usually flattens as short term rates converge with long term rates. However, this time, just like in 2008,
conditions have been so easy, traders use high volume strategies to squeeze
market participants hedging or holding off on future purchases and make yields
actually rally lower. This leads to significant future financial instability
with substantial volatility and potential impacts in the real economy.
The Fed wants to avoid the same mistakes but at the same
time does not want to be held responsible if history repeats with a financial
crisis. They will try to talk rates to
normalization and Fed officials are currently trying to do so.
But with each speech, market starts to move in the direction
of normalization only to be met with high volumes pushing market to even lower
yields. The Fed has to get real and stop this habitually bad behavior. They need to increase volatility in the bond
market and let the volatility regulate bad behavior. The Fed is too transparent
and traders are using a lower volume period – summer months – and lack of economic
releases to push markets around like poker players do. These traders are using the Fed’s proven
misguided monetary policy (which is a repeat of 2006-2007 and we know how that
ended up) as a perceived put option on rates and exercising it with a high
volume long biased trading strategy.
Janet Yellen speech today should acknowledges how broken the
bond market is and disconnected from their policy path or any semblance of
normalization. She, too, will try to
talk a good game. However, the market is
so embedded with large traders with gargantuan balance sheets too large to
reposition for higher rates without hurting their positions, the manipulation
of rates will continue.
To avoid a significant self-made financial crisis, Yellen
needs to walk the walk as well. Yes, a
50 bp hike will stop this behavior. Also,
bringing forward sales from their balance sheet, or let the balance sheet run
off faster would end the manipulative behavior in the bond market that monetary
policy has incubated. This would also be
a savvy way to take advantage of these lower rates instead of getting front-run
by these markets. The sooner the bond
market starts to truly normalize, the less severe the market impact will be
from the overvalued global bond market normalization process. So to avoid the same policy mistakes of the
last tightening cycle and creating a financial and economic crisis, Yellen should
be a little less predictable, knock out that perceived put option on higher
rates and let increased volatility regulate the markets keeping positions
smaller and extreme risk taking at bay. Today’s
speech will be a step in the right direction.
by Michael Carino, 6/27/17
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?