Via Scotiabank's Guy Haselmann,
Market psychology established in recent years is reversing. Investing has taken on profound psychological aspects during the past few years. Investors have had strong incentives to stay in front of the aggressive actions by global central banks to take advantage of their implicit and explicit desire to ‘do whatever it takes’.
The classic investor goal of ‘maximizing return per unit of risk’ was simply replaced by ‘maximizing return’ because the ‘risk’ component was mitigated by implicit promises of additional monetary policy actions if such was determined to be necessary. Hence, the goal of beating peers and benchmarks through higher yielding (i.e., ‘risk-seeking’) securities became the modus operandi.
Most investors assumed that economic and corporate fundamentals would eventually improve enough to justify the elevated valuations of financial asset prices. When improvement continually struggled to be ‘adequate enough’, central banks responded (or were expected to respond) with large-scale asset purchase programs. Companies also helped maintain high valuations, and stable prices, by taking proceeds from debt issuance to repurchase shares, pay higher dividends, and execute mergers and acquisitions.
These actions provided a powerful source of support for financial markets and suppressed market volatility. Buying every dip in risk assets became a prudent, popular, and yield-enhancing tool. Any signs of strong economic data reinforced the belief that frothy valuations would eventually be justified. Weak economic data on the other hand was merely interpreted to mean that monetary accommodation would be maintained for longer or that more would be provided.
There are many examples of weak economic data boosting financial markets due to this perception. (I first addressed this dynamic in my “Down Side Up” note of 5/7/15). This concept was visible on December 1st. ISM was forecast to rise from the prior 50.1 print, but it fell to 48.6 (the price component fell 4.5 points to 35.5) and the S&P rose 22 points (or 1.1%). In another example, payroll employment was forecast to post a 200K gain on October 2nd, but it rose only 142k and the S&P 500 rose 28 points (or 1.4%).
In 2016, investors are likely to shift from ‘buying the dip’ to ‘selling the uptick’. The main catalyst is the fact that the Fed has started a hiking cycle. Some may prefer that I call it ‘the gradual removal of accommodation’. Regardless, the hurdle for the Fed to not hike again is high, and the hurdle to reverse back to an easing path is even higher.
Although the BoJ and ECB continue to maintain their QE programs and the PBOC is offering various forms of support, the diverging direction of monetary policy means less support in aggregate for asset prices. In addition, the marginal benefit of monetary accommodation decreases over time. Could recent market behavior be warning that central bank support is unable to lift asset prices higher without stronger improvement in the fundamentals?
In the meantime, US and global growth seems to be slipping. Chinese market and economic weakness, commodity price pressures, and a strong dollar are all thwarting the stabilization of important emerging economies. And, general uncertainties are intensifying due to escalating geo-political tensions, growing nationalism, and looming elections.
The bottom line is that market volatility is rising and will remain pervasive for a while. The shifts outlined above in terms of market psychology, the change in direction of Fed policy, and the increases in general uncertainties, will all conspire to shape an environment ripe for sharp spikes in volatility. These spikes will be further amplified by rickety market liquidity. Banks and broker dealers have limited appetite and ability to expand their balance sheets, especially when markets need it most.
There still remain strong arguments for owning long-dated Treasuries. The reasons are fundamental, technical, Pension-related, relative, fiscal, regulatory, and due to the Fed’s balance sheet management.
Fundamental – Economists frequently forecast 10-year Treasury yields by adding expectations for growth and inflation rates to a risk premium. This formula has been unreliable in recent years. Poor understanding of factors such as globalization, innovation, indebtedness, and demographics has led to chronic over-estimations. The business cycle might now be turning lower just as the Fed is hiking.
Technical – The Fed owns around 40% of all Treasuries 10 years and longer. The ECB is buying 2X the amount of net issuance. The BoJ remains in full QE mode. There might be a shortage of long dated high-quality collateral.
Pension Demand - Moreover, since 2008, the Pension Benefit Guarantee Corporation has doubled its ‘per participant premium’ and tripled its ‘per unfunded vested benefits (UVB) premium’. These premiums rise on January 1st every year through 2019 and are scheduled to rise by another 25% and 30% respectively. The UVB motivation is to encourage Liability Driven Investment (LDI). The potential demand by the $3.2 trillion in corporate DB plans could be massive and have a profound impact on long Treasury securities.
Relative – The US 10-year yields more than Germany (164 bps), France (128), Italy(67), Spain (50), Norway (85), and Japan (197). It yields 60 bps more than Slovenia and has the same yield as Bulgaria. In a highly globalized world, sovereign yield differentials among developed world economies may be more limited than in the past. A strengthening USD also increases its relative attraction.
Fiscal – The US fiscal deficit has fallen dramatically. Net coupon issuance is expected to fall around 25% to the lowest level since 2008. Without any debt ceiling limits to worry about and due to money market reform needs, the Treasury will be funding a larger amount of its budget deficit with Bills (whose issuance as a percentage of outstanding debt is at the lowest level in almost 20 years).
Regulatory – New capital rules (i.e., LCR) have incentivized banks to move toward more liquid securities with limited credit risk components.
Balance Sheet – The Fed has approximately $215 billion of Treasury securities that mature in 2016 which it will be reinvesting across the coupon curve at auctions. This amount will be the equivalence of 10% to 15% of the entire gross new issuance of Treasuries in 2016.
Their deep liquidity and attractiveness relative to other sovereign yields also means that they could gain a bid as the factors discussed above play out.
I am not afraid of being long 30 year Treasuries into Friday’s employment number. If the number is strong, then risk assets will be sold and the curve will flatten. If the number is weak, then risk assets will be sold aggressively, and the entire Treasury complex will improve.
“Education is what survives when what has been learned has been forgotten” – B. F. Skinner