'Shocks,' 'Panics,' And The Outlook For Safe-Havens

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Summary

Following Donald Trump's election, yields on US 10s repriced sharply.

Now, everyone wants to know what the future holds for US debt.

While I don't pretend to have the answer, I can sure tell you what you need to consider when it comes to owning safe-haven assets in 2017.

Back on April 21, 2015, Bill Gross (the old "bond king") had an idea.

A couple of days later, Jeff Gundlach (the new "bond king") had the same idea. "Let's say you leverage up the German two-year 100 times, that's a 20 percent return," he told Bloomberg TV.

What happened next proved beyond a shadow of a doubt that the market will not hesitate to make even the most revered money managers look absolutely silly. Have a look:

(Note: there seems to have been a bit of confusion as to what I meant when I said "makes managers look absolutely silly." Gross didn't anticipate the rapidity of the move, therefore he wasn't positioned aggressively enough. That is, he was more right than he knew and did not anticipate a VaR shock-like spike. For more, see here).

That, ladies and gentlemen, is what you call a VaR shock.

From mid-April to the end of May, yields on German 10s rose nearly 80bps. In the past, I've used an excerpt from an old JPMorgan note to explain what happened - I'm going to use that excerpt again (my highlights):

The proliferation of VaR sensitive investors, such as hedge funds, mutual fund managers, risk parity funds, dealers and banks raise the sensitivity of bond markets to self- reinforcing volatility-induced selling. These investors set limits against potential losses in their trading operations by calculating Value-at-Risk metrics. Value-at-Risk is a statistical measure that investors use to quantify the expected loss, over a specified horizon and at a certain confidence level, in normal markets. Historical return distributions and historical market volatility measures are often used in VaR calculations given the difficulty in forecasting volatility. This in turn induces investors to raise the size of their trading positions in a low volatility environment, making them vulnerable to a subsequent volatility shock. When the volatility shock arrives, VaR sensitive investors cut their duration positions as the Value-at-Risk exceeded their limits and stop losses are triggered. This volatility induced position cutting becomes self-reinforcing until yields reach a level that induces the participation of VaR-insensitive investors, such as pension funds, insurance companies or households.

Got that? Basically ECB QE drove down volatility, causing vol. sensitive investors to lever up. Then, once things started moving in the "wrong" direction, a self-feeding, circular dynamic was activated.

Note that this has happened before. Most notably in Japan in the summer of 2003. Here's Barclays recounting the event:

In June 2003, bull-flattening came to an end and yields turned sharply upward at an unprecedented speed - the so-called VaR shock. At that time, the bond market had completely ignored the share price strength and JPY weakness intact for several months, causing yields to fall steadily to levels that began to look out of line. Then at end-June, after the 20y auction failed to draw any demand and the US Fed surprised the market with a rate cut of 25bp instead of 50bp, the curve saw uninterrupted bear-steepening.

And here's a visual that shows you the similarities between that incident and the bund shock:

(Charts: Barclays)

Finally, here's a list of memorable events like those described above (via Bloomberg):

  • 2003, June : The prices of Japanese government bonds slumped suddenly, causing Japanese banks to bump up against their VaR limits and sell off their JGB holdings.
  • 2008, October: Widespread market turmoil causes a sharp uptick in VaR across the financial system.
  • 2013, June: The "taper tantrum" sparks a selloff in U.S. Treasuries, with at least one bank reportedly breaching its VaR limit.
  • 2014, Oct. 15: U.S. Treasury market suddenly "melts-up," causing investors to quickly reposition their portfolios.
  • 2015, January: The Swiss National Bank unexpectedly removes its currency floor, causing a further VaR shock.
  • 2015, May: Investors sell German government debt, with market participants labeling the event the latest VaR shock.

Ok, so why am I going back over all of this? Well, because people keep asking me questions about rates.

More specifically, I get a lot of questions about where yields on US 10s (NYSEARCA:TLT) are headed. The truth is, I have no idea. And neither does anyone else. What I do know is that circumstances seem to be ripe for a sharp sell-off.

Recall the following collection of quotes from various big names in economics and finance:

(Compiled by Deutsche Bank)

Clearly, the question is this: How would markets react to a repricing of yields that's much sharper than what we've seen since the election?

Remember, the back-up in yields following Trump's victory is really just the market catching up to fair value. "Starting from such low levels, the rise in bond yields and the steepening of yield curves have reinforced, rather than hindered, the reflationary momentum," Goldman notes, adding that "since Mr Trump's election, 10-year Treasuries have sold off 80bp, reaching a local high of 2.65% and are now closer to 'fair' levels on our macro-econometric framework than they have been since 2013."

(Chart: Goldman)

Ok, got it. So what is the market pricing in? Well, not much, although Trump's election has at least gotten expectations back to December 2015 levels:

(Chart: Goldman)

The question, Goldman continues, is what needs to happen for the market to start pricing in additional hikes (given that the dots predict three hikes in 2017, pricing in a cumulative 100bps through 2018 seems low)? Here's the bank's answer (my highlights):

Sustained economic outperformance would help, but our proprietary index of US economic data surprises is already at a local high and, according to CFTC data, positioning in the bond market is already short. The announcement of a fiscal expansion by the Trump Administration may contribute to pushing yields higher as investors would anticipate an offsetting tightening of monetary policy. Although the fiscal plans could already be embedded into expectations (particularly on the corporate tax front), a 'pro- business' approach by the new Administration could lift expectations further, particularly before the bills hit the Congress floor.

This is where Deutsche Bank's "risk scenario" comes in (and now we come full circle to the threat of bond market "shocks"). Consider the following from Deutsche analyst Masao Muraki (my highlights):

Panic selling of US bonds. We believe the US long-term yield upswing might overshoot around mid-year if risk-off activity (described in risk scenario (1)) does not curtail yield upswing.

If the US 10y yield moves sharply higher (to 3.6% in 2Q) as forecast by our rates research team, we expect increased selling pressure on the US Treasuries by the US banks (unrealized losses in bond portfolios lower the CET1 ratio), agency REITs, and other funds (which hold large amounts of mortgage-backed securities), Japanese financial institutions (which need to conduct loss-cutting bond sales), and the PBOC (which continues to sell US Treasuries as currency intervention). Leverage regulations, electronic trading, and other factors are reducing liquidity in bond markets. We are focusing on possible overshooting too. Many investment managers lack experience in markets with unleashed upswing in the long-term yield, and this environment might trigger panic selling of government bonds and mortgage bonds.

One wonders if this might not be exacerbated by the ongoing liquidation of US paper by the PBoC as the central bank attempts to manage the devaluation of the RMB.

If you've followed along here, your next question should be: Would panic selling in USTs drag yields on bunds and JGBs higher (i.e., would the shock be contagious)?

To be sure, circumstances are different now than they were in the past. For instance, the BoJ's yield curve control is basically a blank check for the central bank to spend as much money as it takes to keep JGB 10s anchored at 0%. Indeed, there's been a push/pull dynamic going on for at least six months now:

(Chart: Goldman)

Ultimately, BoJ JGB buying and Bundesbank bund purchases have succeeded in keeping yields well below what Goldman considers to be "fair value" (compare the following graphs to the fair value chart of US 10s shown above):

(Charts: Goldman)

But there are a number of uncertainties looming on the horizon including, but not limited to, i) the ECB taper, ii) elections in Europe (Germany has federal elections in September), iii) the possibility that the market takes the BoJ to task on the central bank's yield curve control, and iv) rising inflation across the eurozone.

So that's a lot to digest, right? Especially considering the original question ("where do you see the yield on US 10s heading?") seems straightforward enough.

This is indicative of a common problem I see among investors (especially among retail money). They assume, based on the pedestrian commentary they're used to perusing (and on what their local broker probably tells them), that analyzing markets is as simple as looking at a few cherry-picked metrics and then making a trade recommendation. It's never that simple. And it's getting more complicated by the day.

As I've said on too many occasions to count, making "predictions" and giving out trade recos is a fool's errand.

The best way to understand markets is to start with the assumption that in reality we have no idea where asset prices are headed. You start with that truism and then proceed to identify all of the confounding factors.

Once you've completed that exercise (which I've done above), you're in a better position than most. At least then you know that you don't know.

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.