The global bond market just took the biggest two-week drubbing in over a decade. More than one trillion dollars was sold off. Where did it go?
GLOBAL BOND SELL-OFF
In last week's "What We're Watching" we briefly covered the developing global bond rout. The sell-off continued with the Bloomberg Global Aggregate Index falling 5% since the U.S. Presidential election. Barclays Global Aggregate Bond Index dropped more than 4%.
While global bond yields have been drifting up since just after the "Brexit" panic, the jump in rates the past two weeks has been historic. This has greatly destroyed the wealth of investors who were positioned in those bonds.
Given the extremely low-interest rates, including many that were negative, global bond investors could face even more pain short-term. For debt ridden governments, higher interest rates face a grave problem when the time comes to refinance. The bond rout could have a significant negative impact on the global economy and markets short run. Anticipated U.S. growth policies under President Trump would not likely take hold until 2018 or 2019.U.S. TREASURIES SURGE
U.S. treasuries have also surged since the election. Rates on the 10-year Treasury are now at levels not seen since shortly after QE ended. The following chart from Bloomberg demonstrates just how sharp the move after electing Donald Trump to the Presidency has been.
Janet Yellen's testimony to Congress last week signaled that a Fed Funds rate hike is imminent. As we mentioned on Friday, the CME FedWatch Tool is putting the odds of a rate hike at 90% in December.
Fed rate hike expectations and inflation expectations due to economic growth under Trump both are supporting higher rates and lower bond prices. While the trends are clear at this point, preparing for trend changes possibly as soon as next year will require a willingness for investors to be tactical.INFLATION EXPECTATIONS
Bond yields rose on the expectation that U.S. fiscal stimulus will drive inflation. A combination of tax cuts and spending are being seen by some as a panacea for global growth and inflation concerns.
While spending could drive inflation, we continue to point out that megatrends such as aging-demographics are deflationary. Offsetting those structural economic problems will take more than reducing regulation, cutting taxes and re-shoring a few million jobs.
While bringing some jobs back to America sounds good to people who have not had a raise in 20 years, could cause more problems than benefits depending on the outcome. We know that global trade has been falling in recent years. According to the Global Times, China's exports fell 7.3% in October. If we seek to bring jobs back with trade sanctions, would those jobs even exist anymore. It's a very fair question.
For inflation due to growth to take hold, deflationary forces would have to not only be offset, but changed. There is virtually no way to change the aging trends of the planet in a civilized way. Eventually the ratios of old-age dependency, to size of the workforce will be overwhelming. While technology could be helpful to offset a shrinking workforce in coming decades, will it provide enough money to support our elders?
Those are long-term concerns we should not lose sight of. In the short-term, we could simply see policy pull growth forward to generate some inflation. Pulling that growth forward will leave a hole to be filled in the future, something else to think about.END OF THE BOND BULL FOR NOW
Many prominent investors have been pointing to the eventual collapse of the bond market for several years. Doubleline Capital CEO Jeffrey Gundlach said, "Cracks have been forming for five years." Bill Gross has talked about the end of the bond bull market as well in his monthly market outlook. He recently said on CNBC, "I don't like bonds, I don't like most stocks, I don't like private equity."
Growth and inflation expectations could certainly spell the end of the bond bull market. However, what if those expectations are not met? What if deficit spending does not lead to a jump start of growth? It hasn't done much so far, other than cause bigger problems.
One concern is that more deficit spending sets up a return of the bond vigilantes. If global debt continues to rise, then lenders could demand even higher rates of return as corporations and governments continue to look to stretch out their debts.
In a scenario where credit becomes more expensive, that could prevent the type of growth we hope to see. Central banks have been very effective at keeping rates down. Will we need more quantitative easing at some point to prevent even higher interest rates? That is an interesting question.
Central banks have suggested they are near the end of their effective monetary tools. Could rising interest rates be a way for the central banks to reset those tools?
What we really fear is "stagflation." Goldman Sachs has suggested "stagflation" could be in our future due to a combination of structural deflationary forces and the possibility of more expensive credit. Stagflation is not a pleasant thought.ECONOMIC CALENDAR
Wednesday is a big day on the calendar. We will see:
- New home sales which indicate economic growth.
- Michigan consumer sentiment which will let us know if people are still optimistic post-election.
- Federal Reserve Open Market Committee minutes that will give us a glimpse at how hawkish the Fed is becoming.
- Durable goods orders which have been volatile.
- Crude inventories which is an intermediate term harbinger of inflation.
On Tuesday we get existing home sales which will let us know if mobility is indeed continuing to return.
On Thursday we get the important initial unemployment claims, which if good, almost assures a Fed rate hike in December.TACTICAL THOUGHTS
The current trends are favoring assets that do well with increasing inflation. Bonds of course are getting crushed on the other side of that trade. Moving forward, we would expect those trends to continue in the short-term.
In 2017 we will have to see how things develop. There are forces lining up to cause a speed bump.
As tactical investors, we will go with the flow as long as trends remain viable.
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Additional disclosure: @globalviewcap