The post below is the outline text sent for an article in the Australian Financial Review (AFR) looking at the triple threat faced by bond markets. As our recent posts have suggested, we see Bonds as the biggest short and medium term threat to equities, but more important we can see a situation where the yield curve steepens very sharply causing an existential crisis for many bond managers and their underlying investors.
Bonds Face a Triple Threat
We like to think of markets as reflecting the balance of behaviour between three key groups, short term, risk taking, leveraged traders focussing on upside, medium term, largely risk averse, asset allocators looking to minimise downside against a benchmark and longer term investors looking for a trade off between the two. The traders tend to set the ‘narrative’ for the markets since their aim is to move the market in the direction of their existing positions and they largely operate in the Foreign Exchange and Commodities markets, as well as parts of fixed income, where exaggerated macro commentary is encouraged in order to profit from large leverage on small market moves. Thus, currencies and commodities are seen to ‘plunge’ or ‘soar’ according to headlines, when in reality the moves are barely relevant in the real world. These are what we like to refer to as ‘noise’ traders, since the peak of their trade movement will be when they are at their loudest; the story is the most compelling when the last person is convinced. At which point it usually flips in the other direction. Periodically, these noise traders will come into equity market, usually on the back of strong momentum trades and in the last few years this has been something of a first quarter phenomenon. They bring their box of tricks with them, leverage in the form of margin and options and a powerful narrative eagerly picked up by the media and through them other day traders. This year’s short sellers squeeze and the RobinHood traders in tech names was a classic example of this, which is why in terms of analysis we like to consider what we refer to as short term uncertainties. When the traders start to retreat, either because of uncertainty about regulation or the lack of a follow-on buyer or tightening liquidity/margin calls, then it makes sense for medium and long term investors to step back.
Asset Allocators, by contrast, are usually not very leveraged and tend to be much more focussed on not under-performing a benchmark. As such they will buy an asset not so much because they like it as because it’s in the index and they don’t want to risk not owning it, something traders will look to exploit, since creating a forced buyer is a perfect way of exiting your trade. They also appear to work to something of a quarterly calendar, structured around the options expiry dates, when hedging of portfolio positions is either rolled over, or allowed to expire and for whatever reason March has historically been the most important of these. The run up to these meetings – ie the next few weeks -sees lots of meetings and discussions about the big picture and there is no doubt that commodities, inflation and Emerging markets are exercising minds, not least because a lot of Asset Allocators are not positioned for any of this. Thus, while we consider short term uncertainties to assess traders, we refer to medium term risks to look at Asset Allocators. The long-term investors tend to consider longer term trends and will usually buy on dips caused by short term uncertainty/selling or medium term risk rising so long as they believe the long term trend is intact. As such they buy on dips in bull markets but sell on rallies in bear markets, which is as good a definition as any for those terms.
The key point of this framework is that sometimes all three groups pull in the same direction and sometimes they offset one another and right now all three appear to be selling bonds, suggesting that the long anticipated multi-year bear market for bonds may finally be here. The US long Bond has had a terrible 2021 so far, dropping by around 12% and unwinding the whole of the powerful 25% rally that it saw in the first half of last year. Moreover, because the nature of the bond markets is such that everything is priced as a spread off US Treasuries, the rest of the fixed income markets have also moved down with them. Unfortunately, in the short term, long, and sometimes bitter, experience tells us that when the highly leveraged players in fixed income markets sneeze, the equity markets catch the proverbial cold and we remain of the view that the biggest medium term risk to Equity markets remains the structural problems in bond markets. As a source of liquidity, equities are usually hit with some distressed selling as leveraged traders try to unwind their books and the parts of the equity markets that have also been bought on leverage – the day trader favourites – are hardest hit as that crowd also heads for the exits. The rationale for the sell off is macro concerns about inflation and this has been partly fed by the strong performance in commodity markets over the last few months, with Copper prices at new highs and Oil hitting $60 – a far cry from the extra-ordinary moment last April when market mechanics and distressed selling by leveraged retail investors pushed it below zero.
Thus as the short term traders look to have returned to their more usual hunting grounds and are promoting the Commodity and inflation narrative, this is causing some panic among asset allocators who are positioned for neither while the prospect of a capital loss from the Bond portfolio after a decade of QE driven capital gains is creating something of an existential crisis for those long term investors who have convinced themselves that they were being prudent in holding assets with no income to speak of on the basis they were ‘not risky’. We suspect they will start to sell the rallies, leaving equity and corporate cash flows the only game in town. The great Reset may not be economic, but financial.
