I agree with comments that RBS’s Alberto Gallo made to Bloomberg in the past few days. Later this year we are likely to run into heightened bond market volatility, which may well hit stock prices for a while. We could see a battle between the bullish impact of a Republican victory and the bearish impact of rising bond yields.
Going into this year the consensus view, which seemed reasonable enough to me, was that bond yields would rise in 2014. This forecast was spectacularly wrong; long suffering bond bears are further discredited while bulls such as Pimco’s Bill Gross have become even more complacent. It reminds me of the stock market in 1999. Which could set us up for a surprising surge in bond yields (drop in price) later this year, due to:
- QE ends – with the taper completed, the Fed will no longer be buying bonds.
- Rising inflation as the economy continues to grow and labor markets tighten. Obviously labor is not an undifferentiated commodity like, say, soybeans. Even if many people still can’t find jobs, shortages are appearing in important segments such as engineering, nursing, trucking, oil & gas production, etc. By damaging the supply side of the economy, Obamanomics makes the U.S. more inflation prone, something almost no Wall Street economists are talking about. (See our June 21 post.)
- Once bond yields start to drift upward, the fast money (hedge funds) will dump bonds. But market liquidity will be terrible because Dodd-Frank and the Volcker Rule are driving those dastardly investment banks to carry much lower bond inventories. (By the way, in his book Street Test Tim Geithner basically admitted the Volcker Rule made no sense because it is impossible to differentiate between market making and proprietary trading. And prop trading had nothing to do with the financial crisis, which was all about making and packaging bad mortgage loans.) Recent weak profits in FICC are causing investment banks to downsize this business in favor of wealth management; often Wall Street firms make such moves at precisely the wrong time.
- Here’s where it gets interesting. For a long time the dumb money has been “reaching for yield” by taking big risks it doesn’t understand in low quality fixed income instruments. That includes bond ETF’s and mutual funds, which own fairly illiquid long-term assets but offer instant liquidity to individual investors. This clearly worries regulators; last week the Financial Times reported regulators were considering slapping an exit fee on bond mutual funds to discourage mass withdrawals. One of the iron laws of Wall Street is that financial innovations developed to meet ebullient investor demand during a bull market don’t work so well when prices drop and market liquidity dries up. That’s when we’ll find out whether ETF’s are as wonderful as their advocates claim. I have no problem with plain vanilla ETFs, such as SPY, sector SPIDERs, etc., but I would not be surprised to see some bond ETFs malfunction in a bond bear market, shocking investors who thought they were being conservative by avoiding stocks. Will busy-body regulators address this future risk now, or wait for a crisis? I am not optimistic.
I don’t think bond market volatility that drives up 10-year Treasury yields north of 3% will be a disaster for the economy or for stocks. However, equities could well take a hit for a few months as investors snap out of their “new neutral” “low bond yields forever” torpor and reassess the macro landscape.
Postscript: You Heard It Here 18 Months Ago—Endowments Post Poor Returns
A couple of days ago, the WSJ ran an article titled, “Big Investors Missed Stock Rally: Pension Funds, University Endowments Diversified Into Other Investments With Disappointing Performance.” This is consistent with my Dec. 22, 2012 post on “stock avoidance syndrome” where I agreed with Larry Fink’s then-contrarian bullish view of stocks. I noted Ivy League endowment funds had very low allocations to domestic equities and high allocations to “alternative investments” such as hedge funds, private equity, commodities, etc. I wrote, “Individual investors are following the Ivy League money into these ‘alternative investments,’ but will they really deliver attractive returns as money pours in? We’re skeptical.” I have reiterated that view several times since then, most recently in April (Hedge Fund Madness—Providing a Way to Diversify Out of Sound Investments).
The lesson here is that financial markets are susceptible to sentiment swings lasting many years. Institutional investors fell out of love with equities and into love with hedge funds and private equity, which outperformed during the financial crisis but have lagged since 2009 while equities staged a huge rally. Because this surprised the morose media, pundits label it a “stealth rally.” Over the next few years, look for this syndrome to reverse. Investors will shift from hedge funds with high fees, mediocre performance, poor liquidity and limited transparency and back toward equities. Eventually, equities will again become excessively popular, as in 1907, 1929, 1972, and 1999.
Copyright Thomas Doerflinger 2014. All Rights Reserved.
