Is The Chase For Yield Over? - Bezek's Daily Briefing

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Summary

Bonds are selling off globally.

Is the bottom in for yields? If so, what's it mean?

The US dollar is also surging, suggesting the market may be heading for more volatility.

For at least the past two years, many investors have focused themselves mainly on yield. As it became increasingly clear that interest rates would be staying low globally, investors have raced into anything that still offered a decent dividend or interest payment.

The recent unprecedented surges in sleepy sectors including utilities (NYSEARCA:XLU) and REITs spoke to this yield mania. At least for utilities, 2016 looks like a blow-off top, the sort that's followed by a sizable correction:

XLU Chart

XLU data by YCharts

With many yield instruments' charts looking similar, it's worth considering that the hunt for yield may have already ended. Blue-chip dividend shares have taken a real hit over the past quarter. Look at the Dividend Aristocrats (NYSEARCA:NOBL), for example:

NOBL Chart

NOBL data by YCharts

They're much farther off the highs than non-yieldly indices, such as the NASDAQ Composite, which made new record highs as recently as two weeks ago.

And the signs of stress are perhaps most apparent in the bond market. Bonds, globally, appear to have topped in late June/early July and are now heading lower in many places. The US 10-year bond (NYSEARCA:TLT) is making a strong and clear move lower:

Click to enlarge

In Germany, yields have spiked back above 0%, after spending enough time under that line as to set off chatter that we were entering a new era. And after reaching as low as -0.3%, Japanese 10-year bonds are back to within a rounding error of 0%. Even countries such as Japan that promise easy money indefinitely can't satisfy investors anymore.

And in emerging markets, central banks are starting to hike rates again, as economic growth recovers a bit and countries are using that window to hike rates and support their currencies. Mexico is the latest example of this, with its surprise 50-basis point hike recently.

Suddenly, the tide seems to be turning toward higher rates. What's the cause? One thing we can rule out: it's not the Fed provoking this. They've consistently talked about higher rates without actually doing much - their present position is not a significant deviation from past policy.

There appear to be several factors causing the sell-off in yields. The first of these is new supply, particularly with duration. Italy recently issued more than $5 billion in 50-year bonds. Spain and France had issued similar duration bonds, though in smaller quantity, earlier in the year.

It's particularly remarkable that Italy is able to find such demand for 50-year paper. Italy has a vote to potentially overhaul its constitution later this year - if Brexit is any guide, investors aren't real happy with potential political shake-ups.

On top of that, Italy's 50-year bonds aren't eligible for the ECB's asset purchase program, since that program isn't permitted to buy very long-duration bonds. Despite these factors, Italy moved its 50-year bonds at a 2.8% interest rate; just a few years ago, investors demanded more for Italian 3-month paper.

It appears that quite a few other countries are keen on following Italy's example, locking in ultra long bonds at low interest rates. This creates fiscal flexibility for governments, but leaves the credit market sagging under a mountain of increasingly unattractive assets.

As economics reminds us, supply and demand tend to end up matching - if demand for bonds stays unusually high, governments will happily fill the void with increasingly absurd bond offerings until investors cry uncle. In a weird way, this is turning into a new form of taxation for cash-strapped governments.

Another economic principle also applies here. The marginal transaction sets the price for the whole asset class. It's unlikely that most market participants would want to pay current prices for a variety of bonds (and high-yield stocks). There are lots of unrealized capital gains in play.

The people buying bonds now are largely performance chasers, algorithms, indexers and trapped short sellers. It's unclear how much real demand there are for some of today's more absurd bonds, such as no-yield Japanese 10-year bonds, or sub-3% half-century Italian bonds. Many of today's buyers are not permanent capital, and will turn to sellers as soon as momentum swings to the bearish side.

Anyone buying bonds today for technical or momentum reasons can easily flip to the sell side of the equation once a clear top is in. As that US government bond chart above shows, bulls are on pretty shaky ground now, we're heading toward a point where bond prices could flash lower if the late buyers to the party get nervous.

US Dollar Also Surging

As gold owners have been reminded in a most unpleasant manner recently, much of the world's assets are back-door US dollar trades. And the dollar (NYSEARCA:UUP), after a long slumber, is back to its aggressively bullish demeanor:

Click to enlarge

If the dollar climbs over the top of that range, look out, you're going to see some strong reactions in other markets. The weakening US dollar earlier this year put a bid back in commodities, emerging markets and helped support struggling countries including China, Brazil and Russia.

But the dollar failed to break down and the bullish pattern from back in 2014 held up. A surge in the dollar past the 2015 high would set off another tremendous move lower in commodities and emerging markets and also cause another big hit for US multinational firms' earnings.

While it's too early to conclude we've entered a new period, there are signs that say we should be cautious. Bonds are on the cusp of a big breakdown, and the dollar is just a few strong days of trading away from heading out of its range. The euro is still holding onto support - so far it's been mostly the pound capitulating against the dollar. But should the euro break 1.05 and head for parity, things are going to get a lot more interesting for global markets.

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.