YIN & YANG
The FOMC’s statement came and went. Once upon a time we would diagnose these with a fine toothcomb but nowadays we have the 140 characters on Twitter from the Trump to react to instead.
The nuances of FOMC speak are now simply irritating and not useful. The wording in the 1 February statement, however, makes it clear that inflation of two percent has gone from a ‘perhaps’ to a ‘definite’. However, the timing of the next Fed rate raise has not shifted in market assumptions. June is when it was expected and it still is, even ignoring a more than sturdy jump in the Atlanta Fed expectations for 2017 Q1 GDP growth from 2.3% to 3.4%.
If asked, we would assume that 10 year bond yields in the US have moved dramatically higher in the last two months. Actually that isn’t the case, on 1st February 2017, 10 year yields were 2.45 %, the same as they were on 1 December 2016 and the same as they have been, on average, over the two- month period. Despite this apparently boring sideways shuffle, the MOVE Index, which tracks bond volatility, in a similar way to the VIX does for equities, has stayed steady at an elevated level of 71.0. The VIX index, on 1 December, was 14 and at the time of writing is at 12.4, having been as low as 10.5 at the end of January.
So bond prices have stayed steady as equities have continued upwards but bond apprehension, in the form of volatility, remains elevated compared to equity complacency. Consequently, it is interesting that the sectoral driving forces within the equity markets, equity cylicality, have been buoyed by inflationary worries that should be more concerning to the bond markets. The FTSE mining sector, for example, over the two month period of December to February, when bonds have done nothing, is up 14%.
It could be surmised that markets do fear bonds but with the caveat that they expect the Fed to remain heavily behind the curve. There is the presumption that bond yields, especially in the US are going to be governed by the Fed waiting to see the reality of Trump’s fiscal boost. Further, any tightening might take place through the reduction of the Fed’s balance sheet rather than raising rates. Bond yields are of course, a simple mathematical function of adding up all the base rates for the specified time period. There is nothing legally written to say inflation should have any bearing on a bond yield, apart from what investors might do to your currency if you don’t give full recognition to it.
Perhaps that is why investors sense they can get a purer and more profitable return out of equity market inflation than from bonds; perhaps but probably not.
In reality, as most who know me will appreciate, there is more to investing than simply fundamental analysis. There is the necessity to comprehend what everyone else is doing and what they all already know. You can be totally correct in your analysis but if others are all positioned the same way, nine times out of ten you will lose money. As the hoary old Keynesian adage reminds us, ‘markets can remain irrational for longer than one can remain solvent’. This is a different way of saying, ‘everyone has the same position, so don’t keep asking why it’s going wrong.’ Last June, when bonds started to wobble, we fervently warned that markets were very over-positioned for deflationary disaster. Seven months on, the positioning has not only been unwound but fully reversed. Not content at unwinding their long stance back into neutral territory, bond investors have now gone massively short. The underweight position in mining stocks was also historically very elevated and probably took a full six months to get back to even a semblance of neutrality but since New Year we have seen long over-weight positioning occur. Bond liquidity is obviously bigger and easier to reverse than equity sectoral liquidity. What started as a move created out of over positioning has now reversed into a fundamentally justified position totally opposite to what it was. The story has been created to fit what was initially a flows-driven move.
The unwind started before Brexit and Trump but the speed of the reversal has been extraordinary and perhaps unprecedented. We have not only gone from a near record long speculative positon in US 10 year bonds –as shown on the chart below- but we have reversed to a record short in ultra- quick time. Whereas normally a record long would be taken down to neutral, this time, while the market was desperately trying to get back simply to neutral, along came Brexit and Trump to impel them to reverse the positon. Not just cut it, reverse it …really quickly. This is important. The same, but the other way round, has occurred in commodity markets.
8 | ADMISI - The Ghost In The Machine | January/February 2017
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