The bond market has been a bull since 1981. I have been involved in the commodities business since that year and I have known nothing but a decreasing interest environment over the course of my career. I am no youngster anymore, although I'd like to think I still am. For many traders, investors and other market participants there are no memories of double-digit interest rates, at least I have that. In fact, the first mortgage that I took in the 1980's was at 12%, a level that would seem usurious for most these days.
We have lived through a thirty-five-year bull market in bonds, an incredible feat. In the aftermath of 2008, things got silly with short-term rates at zero and 30-year mortgages, if you could score one, below 3% for a while. Now it looks like the wheels are coming off the bond market and I wonder if most traders and investors are aware of the potential. I remember back to the early 80's when one of the traders on the desk at Philipp Brothers proudly told me that he had purchased U.S. government bonds with a 20% coupon. His $100,000 investment had a yield of $20,000 each year for 30 years. I doubt we will ever see those days again but, I also remember my father told me when I took my first mortgage that he got a VA loan in the mid-1950's at 4% and I never thought I would see that rate in my lifetime. Therefore, I have learned never say never.
The selling started in July- It has been a 35-year bull
As the quarterly pictorial shows, every dip in the long-bond has been a buying opportunity. However, the most recent selloff has been different. Since July, the future has moved from 177-11 to lows of 152-24, a decline of 13.9%. There have been other substantial down moves in the long-bond. Most recently, it moved from 166-27 in Q2 2015 to 147-26 when the Fed signaled a liftoff in short-term rates. In 2012, the bond cascaded lower from 153-11in Q3 to 127-23 in Q4 2013, a decline of over 16%. Following the 2008 financial crisis, the long bond dropped by 20% over the span of three-quarters. Click to enlarge Source: CQG
The weekly chart highlights the trajectory of the most recent move. The market is now operating under almost certainly that the Federal Reserve Open Market Committee will hike rates for the first time in 2016 by 25 basis points at the upcoming December meeting. It is about time that short-term rates begin to catch up with the move in medium and long-term interest rates. The economic data in the United States has supported a rate hike for many months and the Fed now has no excuse to wait.
I believe that unlike other dips in the bond market over the course of the years, the bull has tired and the bear emerged taking rates a lot higher than many analysts believe. After all, interest rates are a reflection of economic conditions but they are also reflective of the political environment which has undergone an unexpected revolution.
The election of President Trump is a watershed event for the world
The era of accommodative monetary policy began with the 2008 financial crisis. For the past eight years, central banks have taken control of economies in the U.S., Europe and Japan with tools like quantitative easing and artificially low interest rates. Government balance sheets have swelled because of the policies designed to stimulate borrowing and spending and inhibit savings. However, the election of an administration and legislature that are advocates for economic growth through infrastructure spending, tax cuts and renegotiating trade agreements is likely to end the era of central bank economic control in the world's largest economy.
The central banks have repeatedly told markets that monetary policy alone was not enough to spur economic growth. Janet Yellen and Mario Draghi have both cautioned that fiscal initiatives are necessary as a complement to monetary stimulus.
The election of a Washington outsider, Donald J. Trump, as President of the United States and leader of the free world is a watershed event on many levels. From an economic perspective, we are going to see the biggest infrastructure project in the U.S. since the Eisenhower Administration. The building will create jobs as the nation upgrades roads, airports, bridges and builds security around the Southern border. The project is likely to sail through both houses of Congress as many of the roadblocks to legislation seen over recent years have melted away with the election results.
The need for borrowing will increase rates
While the U.S. deficit is approaching $20 trillion, the incoming administration is operating under the assumption that economic growth, lower tax rates and new trade agreements will eventually lower the nation's debt level. However, a massive infrastructure project will need funding and it is likely that the bond market will be the source of the money needed to begin projects.
As the government's demand for funding will increase in the months ahead, it is likely that they will issue infrastructure bonds which are likely to force yields higher. Just a few short years after buying bonds through quantitative easing the U.S. will get back in the business of selling bonds. If the U.S. economy begins to grow at a faster pace, inflation is likely to rise above the current Fed target of 2% and that will increase bond yields. Additionally, building requires the basic building blocks which are commodities and as raw material demand increases it will put upside pressure on the inflation rate in the months and years to come.
The election results were a mandate for a new course and if the U.S. is successful, it is likely that other nations around the world will follow the example set in Washington DC.
Europe and Japan will follow, as they always do
The invention of the concept of quantitative easing is the subject of much conjecture with economists. Some give credit to John Maynard Keynes for the development of the concept. The Bank of Japan may have been the first to implement the concept but it was the U.S. Fed under Ben Bernanke who used the tool in a massive fashion in the aftermath of the housing crisis and economic meltdown of 2008. Slashing interest rates and QE had become all the rage in the U.S. and many other countries in the world followed the lead. The U.S. ended QE and moved into a very gradual tightening cycle in 2015. I surmise that if the Trump Administration is successful with a pivot to fiscal stimulus, Europe and Japan will follow suit in the years ahead.
Rates are going much higher and equity valuations will suffer
The bear market in bonds that began in July is likely to continue. I believe that a rate hike from the Fed is a no-brainer when it comes to the December meeting but the appointment of more fiscally conservative central bank officials and pressure from the Administration and Congress is likely to lead to more hikes in 2017. One of the victims of increasing interest rates will be equity prices.
A massive stock market rally followed the election, despite a sharp selloff in the immediate aftermath of the shock of an unexpected result. It is likely that a continuation of a bear market in bonds will lead stocks lower in the months ahead as equity valuation has risen to unsustainable multiples. Click to enlarge Source: http://www.multpl.com/shiller-pe/
With the price to earnings multiple of the S&P 500 trading at over 27 times earnings, stocks are historically expensive. Higher interest rates will present competition to equities as fixed income instruments will offer investors more of a choice than they have had for many years.
The selloff in the bond marker currently feels a lot different than pullbacks we have seen over recent years. It may be very dangerous to buy the dip this time. One of the smartest things I heard said about the bond market last year when the bull was continuing to charge forward was that buying bonds amounted to picking up pennies in front of a steamroller. Current yields remain historically low and there could be lots of downside in the bond market in the years to come, that steamroller could be picking up speed. The political changes in the U.S. and U.K. are likely to trigger other nations to reevaluate their current leadership structure opting for more populist leaders and rejecting the status quo.
Brexit and President-elect Trump are signs that the era of monetary accommodation has ended. The bond market move that started in July may have been the greatest predictor of the U.S. election and the great bear market in bonds may just be getting under way. After all, interest rates had nowhere to go after reaching negative levels in Europe and zero in the U.S.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.