As Bond Bear Market Beckons, Veterans Tell Tales of the Unknown
Few on Wall Street can regale tales of yesteryear.
Nowhere is that truer than in the bond market, where a largely uninterrupted 35-year bull run in U.S. Treasuries has become the defining experience for generations of debt traders and investors. For them, double-digit inflation, benchmark interest rates above 6.5 percent, and prolonged capital losses on bonds have only ever been theoretical.
Now, with expectations for U.S. inflation and rate increases climbing, concerns have emerged that the much-feared bear market in government bonds is finally poised to take root -- potentially leaving investors worse off than the 1994 ``bond massacre.''
Here, we present the oral histories of market participants who witnessed both the bear and bull era, braving political and market forces from Richard Nixon's price controls to the global financial crisis. Combined, they have over two centuries of in-the-trenches experience trading and analyzing the $13.9 trillion Treasury market.
Their diverse views are presented below in edited transcripts.
Gary Shilling became the first chief economist at Merrill Lynch Pierce Fenner & Smith in 1979. As president of his New Jersey-based eponymous research firm, the 79-year old guru is still bullish some five decades later.
``Back then, of all the economists on Wall Street, there were maybe 20 of us, and that was it. In 1981, I said we're entering a bond rally of our lifetime. I wrote a book then, `Is Inflation Ending? Are You Ready?' There was so little belief in unwinding inflation that the book was a sales disaster.
I started to get involved in long bonds on a repo basis, very highly leveraged. Initially yields went back up; I was losing money. I was driving around town and I was saying `my God Shilling, you're supposed to be smarter! You got this wrong!' Luckily, I hung on.
I didn't know how long the rally was going to last at that point, but I knew yields were going to go a lot lower. The biggest driver during the 70s was inflation. The correlations between CPI year-on-year and bond yields were very clear. Forecasting yields was basically forecasting inflation.
I've been hearing `inflation's back' forever. There were people saying in 2010, 2011, 2012, 2013, 2014, 2015 that bonds are going to hell, and the world was just fine.
My target is still 1 percent on 10-year Treasuries, and 2 percent on 30-year Treasuries.
You've had a meaningful selloff since the election, on the conviction that there's going to be an instant leap in the economy led by infrastructure spending, and that's going to lead to inflation. My view was it wasn't going to happen. Here's the rationale: Infrastructure spending takes two or three years to be implemented.''
Mike Harkins, CEO of Levy, Harkins & Co., an asset management firm he co-founded in 1979, reckons the world ``couldn’t possibly be more wrongly positioned'' for a secular shift in U.S. government bonds.
``Things were so different back then it's unbelievable. The guy in the street didn't have a clue who the central bank governor was. They weren't rock-star celebrities like they are today. No one knew who Arthur F. Burns [Fed chair from 1970-1978] was. Paul Volcker is six-foot-seven tall, and when I saw him walking around in New York no one recognized him.
I remember the day when he came back early from the IMF meeting in Belgrade, Yugoslavia. That marked a turning point: he realized that in order to kill inflation, he had to hike interest rates like a shot. No one saw anything like that ever before, and no one believed him.
At 4 p.m. on Thursday afternoon, people raced to find out the money supply statistics and tore them apart for meaning. Now, it seems like no one even knows where to find money-supply data.
Back in the late 1970s and early 1980s, when a bond went down by 15 percent but had an interest rate in double-digits, you had such wonderful protection.
That period was crazy. But this period is crazier. As a bond investor, you are now effectively taking equity-like risk but with no return. Austria, for example, issued a 70-year bond in October last year at just a 1.53 percent yield -- and that bond is now down 14 points! You don't have any protection these days to hedge against disasters; there's no income coming through!
This world now is the exact opposite of the world in the 1970s: you can't make money. You can only lose. You are priced as if the possibility of inflation is zero, while back in the bear market, the market psychology was that inflation would never end.
And going forward, it's going to be a disaster for bond markets. Inflation is coming, and valuations are crazy. And then there's Trump. He's a respecter of no institutions or persons. He will make the Fed do his bidding, which means no one can predict the outlook for interest rates.''
Lacy Hunt was an economist at the Dallas Fed before serving as a fund manager at Fidelity Bank of Philadelphia between 1976 and 1982. The 74-year-old economist at Austin, Texas-based Hoisington Investment Management Co., is convinced the post-election rout in U.S. government bonds is, in fact, setting the stage for a rally.
``The main failing of most economic analysis is to assume that debt is costless; that it doesn't matter how you borrowed money, and whether you're doing anything productive with the borrowed money.
I’m still long bonds, especially the long-end. The trend to inflation is still downward. When debt is at high levels and increasingly counterproductive, the most important lesson of economic history is that the velocity of money falls.
We have a long-duration portfolio. We've continued to invest in the long end of the market despite the selloff. We're basically investing against inflation.''
Phil Roth has vivid memories of the secular bear market in bonds and the onset of the bull era, having started his career in 1966. The former chief technical market analyst at Morgan Stanley -- an expert on the stock market cycle versus its bond counterpart -- waxes lyrical on the new era.
``In the 1950s, respectable Ivy League students wanted to go into the bond markets. Now, none of these guys are attracted to the market.
The commissions for sales and trading activities for stocks and bonds have collapsed, and I think it's appalling. When the cost of a trade is next to nothing, you have lots of noise in the market. And because of a drop in trading profitability, brokers are not investing much money in good quality research.
It's certainly much harder to analyse markets because they are so globalized. But ultimately, I think interest rates are driven by growth and inflation expectations.
The stock market is going to have a number of corrections as interest rates reset at higher levels. But it may not be hugely disruptive. We are not going to correct the bond bull run overnight. There will be years when the market does well, and years when the market does badly.''
William Fleckenstein, is an outspoken hedge fund manager who started his career in 1979 as a broker and investment manager across asset classes. The much-feared unraveling of the government bond market is finally nigh, he warns.
``When Volcker hiked rates by 200 basis points in late 1978, no one believed in him. The price of gold even eventually doubled.
Psychology today is the opposite. Markets believe these idiots so much that even when they blow asset bubbles and those bubbles burst and then they do the exact same thing -- keeping rates too loose -- people still think it's going to work. They have created a monumental duration-risk bubble.
Market players are prisoners of the past. Most investors haven't seen a bear market, they have only seen spoon-feeding of markets from policy makers. I suspect the 35-year-old bond market bull run ended in the summer.
These days, if you try to make sense of markets on a day-to-day basis, you will drive yourself nuts. Lots will be said about the details like algorithms and foreign demand. But what matters beneath the surface in the bull market and the bear market is the same: debt ratios, budget deficits, inflation and the structure of the economy.
Big inflexion points in bond markets happen every 30 or 40 years. I think this inflexion point is happening now, and it's a big deal.''