Summary

  • Fading the global bond rally has quite obviously been a fool’s errand thus far.
  • But with central banks bent on engineering inflation and with everyone on one side of the boat, it’s possible to make a simplistic contrarian case.
  • Although not for the faint of heart, don’t rule out the possibility of a bond unwind.

In the July edition of BofA’s closely-watched Global Fund Manager survey, “Long USTs” was identified by respondents as the “most crowded trade” on the planet for the second month running.

That’s a reflection of the market’s downbeat take on the prospects for growth and inflation at a time when the simmering Sino-US trade dispute continues to weigh on sentiment and the global manufacturing slump threatens to spill over into the services sector and, ultimately, the labor market.

(BofA)

Inflation expectations in Europe have collapsed, although Mario Draghi’s Sintra speech and the announcement of Christine Lagarde as his successor helped put a floor under things for the time being. In the US, the Fed continues to fret about persistently undershooting their inflation target, and everyone from policymakers to President Trump and his advisers have cited low inflation as an argument for cutting rates despite the otherwise stable economy.

Between expectations for central bank accommodation, the pricing in of a lower neutral rate and the cloudy outlook for the global economy, bonds have surged, driving yields into the floor and swelling the global stock of negative-yielding debt to new highs in excess of $13 trillion.

(Heisenberg)

Amid the reinvigorated hunt for yield, investors have been pushed out the risk curve, down the quality ladder and forced to take on more duration risk. Recall this from a recent Bloomberg article:

But just look at the math. The Macaulay duration on a Bloomberg Barclays sovereign-debt index is near a record high of 8.32 years, meaning just a one-percentage-point increase in yields would equate to more than a $2.4 trillion loss.

I’ve mentioned that in these pages before and it’s something that everyone should keep in mind as the “duration infatuation” proliferates. Arguably, one of the biggest risks facing markets today is a sudden bond selloff that sends yields sharply higher, forcing an unwind of crowded rates positioning. This is the dreaded “tantrum”/”VaR shock” scenario.

There are good reasons to believe the risk of that unfolding is overstated. For instance, according to Goldman’s positioning metrics (one CFTC-based measure and a shorter-term options indicator), the risk of an abrupt, sharp rise in yields isn’t as acute as it was in 2015, prior to the famous German bund tantrum, for instance.

(Goldman, current through July 12)

That said, some market participants enjoy viewing things through the lens of what one might call “simplistic contrarianism”, where that just means taking a look at how everyone is leaning and tilting in the other direction on the assumption the crowd is probably wrong.

That’s been a tough trade when it comes to bonds amid the voracious rally, but for anyone inclined to go against the grain, I wanted to point out the following chart from the latest edition of Barclays’ global macro survey:

(Barclays)

The annotations speak for themselves, but just in case, note that investors were generally spot on from the beginning of 2018 until Q4 when it came to projecting where 10-year US yields would be at the end of the quarter. Since the turn of the calendar, however, those projections have been woefully out of step. Have a look at the last annotation over there on the right-hand side of the chart. Investors now see the bond rally continuing.

As the note at the bottom of the visual makes clear, Barclays’ house view is that still subdued inflation and lower estimates of the neutral rate will probably keep rates low. I happen to share that view, but one shouldn’t lose track of the fact that the Fed is now actively trying to engineer inflation with preemptive rate cuts when the unemployment rate is still sitting near a five-decade nadir.

The irony, amid all the talk about the Phillips curve being “dead”, is that it is, in fact, doing what it’s supposed to do, albeit at an “angle” that suggests wage growth isn’t likely to stage its usual late-cycle “straight line” acceleration.

(Deutsche Bank)

“In a strange twist of fate, the Phillips curve is now is fully ‘alive’, doing what it is supposed to be doing, only to be half-ignored”, Deutsche Bank’s Aleksandar Kocic wrote in a July 12 note.

Obviously, fading the bond rally has been a fool’s errand so far, but with everyone on the same side of the boat, it’s worth noting that central banks are now engaged in a full-on, coordinated effort to reflate the global economy. If they are any semblance of successful and if China decides to abandon piecemeal, targeted stimulus in favor of the kitchen-sink-style approach folks have been patiently waiting on for at least six months, things could swing back the other way in a hurry.

That’s something to keep in mind for anyone who’s all-in on bonds which, according to the same Barclays survey cited above, are the most popular since 2012.

(Barclays)

The Heisenberg Report

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.