Last week, we promised a more detailed explanation of our current market views. We want to concentrate this week on bonds, where frankly we believe price action makes more sense than in equity markets. To set the scene, we are positively disposed to US bonds especially compared to core European bonds which we continue to believe offer extremely poor value. With no new obvious source of growth and poor demographics, record high levels of debt almost everywhere and wide and/or worsening inequality in many Western countries, the world economy remains in the “muddle through” phase at best. In fact, considering the mature phase of the economic cycle, coupled with global monetary policy makers now tightening monetary policy, we believe that there are opportunities in some high quality fixed income areas. This all needs some further explanation, so let’s dive in.

First, we show in chart 1 below the history of the US 2s10s yield curve, the components of this iteration of the yield curve and the Federal Funds target rate. If we start by looking at the Fed Funds rate (in blue), it is clear that as the Fed raises and reduces interest rates, the 2 year bond yield broadly follows. This makes sense. However, the Fed has less control over longer dated bonds which are affected by factors like inflation expectations, term premium as well as the expected path of short rates in the future.

As can be seen clearly in measuring the difference between the yields on the 2 and 10 year bond (the green line in the lower panel), there can be some large swings over time. Historically, zero or a bit below is the lower boundary and between 250bps and 300bps is the upper boundary. As we all know, the post Great Financial Crisis (GFC) recovery has been like no other in some respects, especially when looking at US monetary policy. With QE designed to takeover from interest rates in stimulating the economy, academics designed a shadow Fed Funds rate to measure this extra accommodation. We have noted with the white vertical lines the date that this so-called shadow Fed Funds Rate bottomed at nearly minus -3%. We can argue later whether the Fed’s tightening cycle started at the low of the shadow rate in May 2014, or the first rate rise in December 2015, but what is obvious today is that the Fed is tightening policy, which is leading to a narrowing between the yields on 2 year and 10 year bonds; a flattening of the yield curve.

Chart 1 – US 2s10s curve with Fed Funds rate

The reason the above chart is so important is implied in chart 2 below, which shows the US 2s10s yield curve (in green) and US real GDP year on year (in red) with recessions shown by the shaded areas. We have advanced the yield curve by 12 months. There is no one single indicator that has a flawless track record in forecasting US recessions, but if we were marooned on a desert island and offered only one indicator, we would choose the yield curve. As can be seen, the last three recessions were preceded by the curve inverting (10 year yields trading at less than 2 year yields).

For what it’s worth, movements in the yield curve are not that bad an indicator of future changes in US growth, with the late 1990s period being an obvious exception when the flattening yield curve prevailed for some time as the economy performed strongly. We would suggest that this is the anomaly. In the late 1990s, the internet led to a mini (but ultimately temporary) surge in productivity. As noted above, we are struggling to see any new sources of growth in the next few years, other than a fiscal splurge that seems less likely today than it did the day after the US election last November.

Chart 2 – US 2s10s yield curve and real US GDP growth Y/Y %

So, without going into a deep dive on the current and prospective performance of the US economy, our simple road map is that the Fed is raising rates, and unlike last year, seems intent on doing so (and possibly reducing its balance sheet) almost regardless of the performance of the real economy – the Q1 miss is being dismissed as transitory by Fed members. As indicated by the Bank of America Merrill Lynch chart we show again below, once the Fed commences a tightening cycle, they continue until something breaks, either at home or abroad. We believe that the Fed will continue tightening policy until something breaks, and this will be apparent by a further flattening of the yield curve as the 2 year bond yield rises but the 10 year bond yield remains steady or even drops if recessionary signals increase.

Chart 3 – The history of Fed tightening cycles ending badly

We detailed several times during late Q1 how we were happy to lean against the “reflation” narrative that was popular in the markets at the time. We were happy to express this view by owning US 10 year bonds via the futures market, and have remained long since near the lows in March. However, even if we are right that the yield curve flattens in the months ahead, this can occur with 10 year yields chopping around sideways or moving lower. We have enjoyed a nice little run in our fixed income positions and we have begun to take profits as we worry that price may be entering a short term consolidation phase – to be clear, we will be reducing our exposure as a tactical change due to market pricing and positioning only.

Chart 4 illustrates the 10 year Treasury Futures price alongside speculative positioning. What concerns us right now is that speculators have moved from being record net short in bonds to the longest net position since the GFC. To look at the situation at a more granular level, that shift in net positioning has occurred as long positions (green line in lower panel) have exploded higher. Yes, short positions remain quite elevated, and further covering of those positions could push prices higher, but with a near record long position now held, there has to be room for some long position liquidation if economic data improves. We are therefore taking some profits as we don’t want to get caught on the wrong side of a temporary squeeze on long positions.

Chart 4 – US 10 Year Treasury and speculative positioning

Broadening out the discussion here, and as mentioned at the beginning, we continue to believe that core European bonds offer no value to investors today. Long-time readers will remember that we railed against the negative yielding bonds last Summer, and although longer dated bonds now offer a positive yield, shorter dated bonds do not. This can only last so long as the ECB is pursuing both QE and negative deposit rates, however, as explained last week, the European Central Bank appears to be moving away from these extreme policies.

With monthly asset purchases down from EUR80 billion to EUR60 billion, the ECB has only committed to maintain this pace until year end. Some in the market believe that the ECB will update their plans for next year at their June meeting, however, we suspect that they will wait until September. What is clear is that without a new crisis or plunging inflation, the ECB will be reducing QE further next year. We also suspect that they are keen to raise the deposit rate from the current minus -40bps back to zero as soon as practically possible. It is important to understand that even amongst central banking elites, there is no accepted wisdom that negative rates are either effective nor desirable over the longer term. And on this note, developments late Friday, with reports that Merkel wants Jens Weidmann to take over from Mario Draghi when he steps down in late 2019, may well add to the pressure for normalising rates next year.

So, assuming we are right that core European yields are only trading in negative territory today because of QE and negative rates delivered by the ECB, then are we right to assume that these bond yields will move into positive terrain as the ECB exits these extreme policies? We think so, and we think the process grinds on over the next 12 months and more. We also think an elegant way to attempt to profit from this trend is to short 5 year German bonds versus being long 5 year US Treasuries.

Chart 5 shows the relationship between the two. In particular, the green line in the lower panel measures the yield difference between US and German 5 year bond yields, and as can be seen the jump higher post the Trump victory pushed the difference to a historically very wide level. So the question here is simple. There appears to be an elastic band between these two that implies that the difference cannot remain above 200 basis points for that long. If so, what future outcomes will cause the difference to narrow or widen?

Chart 5 – US 5 year yield versus German 5 year yield

Perhaps the first point to make here is the obvious one. If nothing happens and yields simply remain the same, then our long US versus short Germany will pay us more than 2% per annum which is a nice carry trade in a near zero rate world. As noted, we are assuming that German yields cannot move much lower and even if the ECB ultimately has to do more, German yields cannot move much lower than the recent lows of minus 60 basis points. We therefore argue that the downside from the German leg of our trade is about 25 basis points. We would also assume that an event that caused the ECB to go all out again would be enough for the Fed to stop tightening policy, and perhaps even start cutting rates (let’s not forget that several FOMC members keep telling us that they may have to do more QE during the next recession).

So the risk in our trade is that US yields rise more rapidly than German yields. And although this is perfectly possible, as we have noted, our belief is that the Fed will tighten policy until something breaks, which for the 5 year part of the curve means that any meaningful rise in yields due to Fed policy will likely be either ignored by the market as the yield curve flattens or quickly reversed as the Fed tackles the crisis that they create. In the meantime, if no reflation of deflation event transpires, we will collect our 2%+ carry.

Of course, there are no guarantees and certainly no free lunches in financial markets, but we do think that this trade can work in both a mildly “risk on” environment (as seen so far this year during which time the yield spread has narrowed from about 245bps to 215bps), and in a “risk off” environment as the Fed reverses course. The environment that hurts this trade is a unilateral reflationary environment in the US, which was clearly the initial market reaction when Trump was elected (and the spread jumped from 170bps to 260bps in short order). As we have explained several times since the Trump victory, we do not see the US reflation trade as a realistic outcome; certainly not to the degree that could cause the yield spread to gap by the same amount as last November/December.

If Trump can get his growth policy agenda back on track, we suspect that the yield spread would widen but at a more modest pace. However, our original doubts of the ability of Trump to deliver a meaningful growth agenda have only been strengthened by his performance since he took office.

So again, recognising there are no free lunches, we really do like the look of the long US 5 year versus short German 5 year trade, as it pays a very nice carry for simply holding the trade. We have not been hurt by the trade during the equity market extension seen since February and we would expect a very positive return if markets shift to a risk off period which would no doubt lead the Fed to scale back on their monetary tightening process.

So to wrap up our bond market thinking, we are modestly long US 10 year bonds as we see the Fed on a tightening path until something breaks, which would no doubt then drive bond yields lower. We expect the yield curve to continue to flatten in the months ahead as well. On a relative value basis, we are long US 5 year bonds versus short 5 year German bonds. In fact, this is our single biggest trade in our multi asset macro fund.

Next week, we will go into detail about our equity market thoughts and current trade ideas. As we have detailed at length, the fundamental back drop is that long term equity returns are very likely to be poor because equity markets have risen so much since 2009 and valuations are expensive, especially so in the US. But valuations don’t drive short term market performance; investor sentiment does. We have been waiting patiently for signs that sentiment towards US equities is about to change, and the current market setup is extremely interesting to us.

As noted above, we have been taking some profits from our US bond holdings, and we have taken those profits (and a bit of extra capital) and invested that into bearish option strategies. We will examine these in more depth next week, but with a maximum pay out of 7.3:1 from these options, and our loss limited to the premium paid, we believe that our potential reward if we are right is very good compared to the capital we are risking. We even got a little excited when US equities sold off mid-week as Trump’s troubles escalated, although the bounce into the weekend was obviously frustrating. We will go into more detail on this next week.

Stewart Richardson
RMG Wealth Management