No Matter How Long 'The Unthinkable' List Becomes - It Keeps Representing 'The Untouchables' For Us

Feb. 17, 2020 4:20 PM ETBBEU, BKLN, DXJ, ECH, EDEN, EIDO, EPHE, EPOL, ERUS, EWA, EWC, EWD, EWG, EWJ, EWL, EWN, EWT, EWU, EWW, EWY, EWZ, EZU, FEZ, FXI, GSY, HEDJ, HYG, HYLB, IEF, IEI, IEUR, IGIB, IGSB, INDA, IWM, JNK, LQD, MCHI, NQCZ, PIN, RSX, SCHR, SHYG, SJNK, SPIB, SPSB, SPTL, SRLN, TLT, TUR, USHY, USIG, VCIT, VCLT, VCSH, VGIT, VGK, VGLT, AGT, ARGT, EWO22 Comments25 Likes

Summary

  • Option one: It's me, missing out on the 5th decade of the greatest bull market that bonds have ever witnessed.
  • Option two: It's a huge amount of money that keeps chasing the fumes of what used to be called "yield".
  • Just as a 46% YTM on Greek government debt has turned into 1%, bond bulls expect the current yields, to keep moving lower.
  • Thing is, that from the current historically low levels, such a move is technically/mathematically less probable, and surely not making the same sense.
  • Add to that an inflation rate that is slowly but surely climbing, and the setup for a perfect storm keeps building up.
  • Looking for a helping hand in the market? Members of Macro Trading Factory get exclusive ideas and guidance to navigate any climate. Get started today »

Few days ago, we've touched upon the unbelievable move down in yields on Greek (GREK) government debt. Although there's nothing similar among the western world to that crash of yields on those "ouzo bonds", falling yields isn't only a universal phenomena, but it's reaching unprecedented levels that (in turn) are going to lead to unthinkable outcomes.

In case you've missed that, last week the US has issued a new 30-year Treasury bond with a yield of only 2.06% - the lowest yield ever.

The previous all-time low for a 30-year sale was 2.17% in October 2019, and it may not be too long before the US is able to issue such a long-dated bond.

Nevertheless, it's important to note that the US issuing a 30-year debt at the lowest-ever yield doesn't correlate with the lowest yield such debt has traded at. As a matter of fact, US 30-year yield already dropped below the 2% mark few times in recent months.

I don't know about you, but getting 2% a year for a bond that I need to hold for 30 years (in order to secure this 2% yield) isn't a deal I consider attractive.

Many investors don't understand how great is the risk embedded with holding such a long-duration debt.

Without getting into the exact mechanism, let's just say that when you buy a long-duration bond, you gain a lot when yields move down, and you may lose a lot when yields move up.

Image result for yield duration

On one hand, you have examples like the Austrian century bond (EWO), or even Greek 10-year bond, where investors have made huge gains. On the other hand, you have the Argentinean century bond (ARGT, AGT) that shows you how dangerous - and harmful - long-duration can be when things don't exactly work the way you've anticipated.

Sure, the US is not Argentina or Greece, and a 30-year bond has a much shorter duration than a 100-year bond. Nonetheless, when you buy a "safe" asset like a US debt, you expect the price to hold up quite steadily, right?

Trust me when I say that if and when yields move higher, it would be of little consolation (for you) knowing that you're down "only" 20% on your US 30-year bond instead of 60%, as could be the case had you been holding a century bond (even one issued by Austria) when yields move up only 1%.

Investors are still earning an extra of almost 2% when they buy 30-year US Treasuries (TLT, SPTL, VGLT, IEF, IEI, SCHR, VGIT) compared to German (EWG) Bunds with a similar tenor. This spread is off the highest 2.4% level we've seen few months back, however it's still well above the historical average.

The funny thing is that this unthinkable low yield is coming at a time when the US is issuing more and more bonds, lifting both the absolute (total debt) and relative (debt/GDP) debt levels to new-historic highs.

Image result for US federal debt percent of GDP

That historical low yield on the 30-year isn't happening in a vacuum. The entire credit market is currently full with unprecedented data/numbers.

US Investment-Grade ("IG") bond (LQD, VCIT, VCSH, IGSB, IGIB, SPSB, SPIB, VCLT, USIG, GSY) yields have fallen to 2.57% - a new record (average) low.

To put that into perspective, these type of bonds yielded (on average) about 9.32% (!) at their peak, back in October 2008.

Meanwhile, things are looking as strange/stretch among the High-Yield ("HY") bond (HYG, JNK, BKLN, HYLB, SHYG, SJNK, USHY, SRLN) space.

While today US HY bonds are barely yielding 5%, an all-time low of course, back in December 2008 they yielded about 23.3% (!)

Many investors are living in some sort of an illusion, thinking that the phenomenal yields that bonds have been delivering in recent years are the norm.

That's not only an irrational thinking, but it's actually a near-impossible outcome, mathematically.

Sure, from time to time, there can be a year that delivers an outsized return even on US Treasuries, however that's neither the norm, nor the expected outcome when the rates/yields going forward are as low as they are today.

The latest round of interest rate adjustments has seen the following countries reducing their benchmark rates:

  • Philippines: -25 bps to 3.75%; 4th rate cut over the past year.
  • Russia: -25 bps move to 6.00%; 6th rate cut over the past year.
  • Mexico: -25 bps to 7.00%; 5th rate cut over the past year.

This latest move by the Mexican central bank has brought the total number of interest rate cuts since the Lehman Brothers bankruptcy to 800!

800 rate cuts, worldwide, and counting...

The most recent outlier is Czech Republic (NQCZ) that hiked rates by 25 bps to 2.25%. This was the country's 9th (!) hike over the past 3 years.

Looking back at the last year we've seen the following central banks cutting rates (sorted from the largest to the least aggregate cut):

Turkey (TUR): -1275 bps

Brazil (EWZ): -225 bps

Russia (RSX, ERUS): -175 bps

India (PIN, INDA): -135 bps

Mexico (EWW): -125 bps

Indonesia (EIDO): -100 bps

Philippines (EPHE): -100 bps

US/Fed (SPY, DIA, QQQ, IWM): -75 bps

Australia (EWA): -75 bps

Thailand (THD): -75 bps

Malaysia (EWM): -50 bps

South Korea (EWY): -50 bps

China (MCHI, FXI): -16 bps

Eurozone/ECB (VGK, EZU, HEDJ, FEZ, IEUR, BBEU, IEV): -10 bps

Denmark (EDEN): -10 bps

Thing is, when you look at the current yields offered by leading bond ETFs - there's much reason/substance to be hopeful when it comes to future returns.

Take, for example, the yield on HYG, the largest high yield bond ETF, which is now only 4.46%. That's low. Very low actually.

To put things into perspective, in 2007 you were earning on cash a higher yield than what the HYG currently offers.

These extremely low yields are coming at a time when inflation seems to start raising its head (although it's too soon to make this a conclusion/trend of course).

Based on the recent data, US inflation is now 2.5% (Y/Y) - the highest level we've seen since October 2018.

Again, it's way too early to assume that inflation is going to rise meaningfully from here, but when the real rate (=nominal yield minus inflation) on HY is already below 2%, investors have to ask themselves what type of return they can realistically expect from these types of instruments going forward.

Believe it or not, but the entire US Treasury yield-curve is currently trading below the inflation rate for the second time in history.

When was the first time? Not too long ago - in late 2016, at the beginning of the Fed's short-lived tightening cycle.

This time round, the Fed isn't alone, as central banks are easing globally in a typical late-cycle environment.

Based on current inflation rates, across the globe, here are the real rates of various countries, as measured by the 10-Year yield minus inflation rate (from the most to the least negative real rate):

  • India: -2.4%
  • Poland (EPOL): -1.9%
  • Eurozone: -1.9%
  • Sweden (EWD): -1.8%
  • Chile (ECH): -1.8%
  • Denmark: -1.5%
  • China: -1.3%
  • Australia: -1.1%
  • Czech Rep: -1.0%
  • Switzerland (EWL): -1.0%
  • Japan (EWJ, DXJ): -0.9%
  • Turkey: -0.9%
  • US: -0.9%
  • UK (EWU): -0.6%
  • Canada (EWC): -0.5%
  • Taiwan (EWT): -0.4%
  • South Korea: -.3%

And if the low yields, higher inflation rates, and negative real rates aren't enough to scare you off, how about the massive amount of money that is still pouring into these bonds?

According to BofAML and EPFR Global data, we've just seen the weekly period with the biggest inflow, into bond funds, ever!

Bond funds have absorbed $23.6 (left chart below), bringing the annualized pace of 2020 closer to $1 trillion mark (right chart below).

Btw, equity funds have also seen a sizable inflow of $12.5 billion, bringing the 2020 annualized tally to $443 billion.

For now the "everything rally together" narrative remains intact: US stocks are up, bond yields are down, and the yield curve keeps flattening.

Nonetheless, this confusing narrative won't (and can't) go on like this forever.

The bond bulls who keep pouring billions into all kinds of debts (or those that don't find anything else to do with their money) are expecting the US Treasury 10-year yield to fall to (or closer to) zero.

The bears are looking at the ~$13 trillion pile of negative-yielding debt, making a simple math, and reach a conclusion that the potential loss is enormous, and not only on debt with sub-zero yields (where the loss, if the bind is held to maturity, is certain.)

We've already pointed out at a few disturbing/unreasonable developments across the credit market that prevent us from buying bonds these days.

Sure, there are always exceptions - single opportunities that catch our attention, and money. Nevertheless, as an asset-class, this isn't only bubble, but this is a bubble that may burst sooner than the "at least few years ahead" that many bond investors currently anticipate.

That, of course, if they see a bubble in the first place, and/or anticipate this bubble to burst at all.

As far as we're concerned, no matter how long the list of "Unthinkable" becomes, it remains a list that we also refer to as "The Untouchables", and not in a good way as the below fellas represented.

No matter how Many types of bonds are becoming part of "The Unthinkable" List, they Keep making "The Untouchables" list too, as far as we concern

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