The Bear Market in Bonds Already Looks Shaky
The New Yorker magazine once ran a cartoon depicting two politicians sitting in an office in the shadow of the Capitol, with a man behind the desk saying, “Those who ignore history are entitled to repeat it.” That sentiment looks especially relevant to traders who specialize in using borrowed money to make big bets on U.S. interest rates.
These players are once again engaging in their annual New Year’s ritual of large-scale wagers that lower bond prices are ahead. And who can blame them? In recent years we have witnessed a predictable pattern: Bond bears believe that this time is different, and that the Federal Reserve won’t be spooked by unpredictable events such as a weak first quarter for the U.S. economy, the shock of a hard exit by the U.K. from the European Union, or a meltdown in China’s markets. Those have all caused the central bank to put off normalizing the suppressed rate structure put in place eight years ago amid the worst financial crisis since the Great Depression.
Things are never really different, though, and the bears are bound to be disappointed again.
It’s hard not to be mesmerized by the gyrations in the bond market. The "fast money’’ traders have become emboldened by the stunning 1.25-percentage-point, near-doubling of 10-year Treasury yields since the Brexit vote at the end of June. The bearish bias only got more severe after the U.S. election. No one wants to own bonds with yields not far from historic lows and with President-elect Donald Trump promising tax cuts, regulatory reform and big infrastructure spending within 100 days of his inauguration.
Yet it may be smarter to break away from the screens and search out more experienced, patient bond investors for guidance. They know how crazy January often is in markets as the fast money tries to make a full year’s profit in the first month after being reined in by the always moribund holiday period.
The pension funds, insurers and other "real money’’ investors who need bonds regardless of the environment are taking advantage of the backup in yields to put money to work, a trend that is helping to stall the selloff and even spark a sneak rally in the rates market. Global bond funds took in a huge, $8.4 billion of new money last week. And, there are signs that foreign buyers are starting to return to the market, as evidenced by the more volatile overnight trading sessions.
Overconfident bears may be calling this rebound a “healthy correction,” seeing the opportunity to add to bets that rates are only going higher. The leveraged, higher-rate believers hold record short positions, particularly in securities due in two to five years, which are more sensitive to Fed rate increases.
Luckily for them, the fundamental rationale for expecting two to three rates hikes from the Fed in 2017 remain intact. Global purchasing manager index reports have surged, U.S. consumer and business confidence measures are at multiyear highs, and wage pressure was evident in the jobs report for December. Yes, the core retail sales released Jan. 13 were tepid, but the extreme tightness of the U.S. labor market is likely to power further wage gains and bolster consumer spending.
Key events this week may help determine what comes next in the rates market. The Labor Department is likely to say Wednesday that the consumer price index rose 0.3 percent in December, bringing its annualized gain to more than 2 percent for the first time since mid-2014. The European Central Bank, which can almost always be counted on to deliver a surprise, meets Jan. 19. Finally, the U.S. inaugurates Donald Trump as president on Jan. 20.
January is already proving that 2017 will be a roller-coaster ride in markets, rather than a slow, steady climb for rates. Maybe the fast money traders should look to inspiration from George Santayana: "Those who cannot remember the past are condemned to repeat it.’’
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