Diary of a Financier

“The bond market is always right”

In Capital Markets, Idiosyncrasy on Sun 1 Jun 2014 at 22:33

Cullen Roche over at Pragmatic Capitalism recently asked “What’s the bond market telling us?”  His answer was as follows:

“The bond market is telling us that inflation is currently low. But don’t assume that those bond traders are necessarily right about future inflation expectations…”

Factually, that shot is wildly off-target, but it’s the prevailing consensus I’ve been reading and hearing.

My own answer looked at the data…

I’m going as far as to call the bond market wrong here [attributable to a #Recency bias]. A 50bp+ drop in 10y seems myopically focused on -1% Q1 GDP. Q2 is tracking higher (3-4%), confirming the weather-related, pent-up demand argument. (Look at rail traffic +4.2% ytd, durable goods/CapEx all +3% y/y after q1′s GDP inventory drawdown, and strong ISM/PMIs.)

Doing the math using [the current $TNX nominal yield and] TIPS implied figures:

2.48% 10y = 0.26% TIPS real GDP growth + 2.22% inflation average annual for the next 10 years

Now, that 2.22% avg annual inflation might be too high for the next decade’s average, but the 0.26% avg real growth is way too low for my taste — even factoring-in 1 or 2 recessions. A 3% 10y seems fair to me, considering a 2% real GDP trend, 1.6% PCE run-rate, 2.48% 5y5y forward inflation breakeven¹, and a recession in there somewhere.

If Tsy buyers are afraid of US corporations’ health, then IG & HY spreads wouldn’t be at record tights. (I don’t think these absolute and relative HY spreads are sustainable, but you’d be seeing a widening if bond-buyers were flying to safety.)

At very most, we’ve fallen to a 2.40% 10y because of technical reasons:

  1. Correlation trade w international CBs verbally committed to further QE/easing
  2. US pensions reallocating to a glide path

~~~~

First off, those involved in capital markets should refrain from the use of “always.” In finance, there are no inviolable laws and certainly no guarantees, but far too often I hear some maxim about the bond market being some unwavering, smart money, north star.

Second, objectively, the bond market is forecasting low growth, not low inflation.  I’m definitely going as far as to call the bond market wrong in that assumption. With the 10y now < 2.50 and implying an average annual real GDP growth rate of 0.26% over the next decade, I’m taking the over.

As always, the money where my mouth is. I’ve beat-the-drum twice when the 10y stretched over 3% recently, and twice (I & II) we tactically bought duration then enjoyed a 50bp retracement in TNX. I’m selling duration now, because base rate yields like the 10y will rally from here. I hate credit at these spreads too, so our tactical fixed income allocation is getting tucked into cash.

–Romeo

¹5y5y TIPS implied forward inflation breakeven updated as of 5/30/2014

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  3. Another comment dropped in response to:

    The Case For Higher Rates Looks Weak … Again | Capital Spectator

    http://www.capitalspectator.com/the-case-for-higher-rates-looks-weak-again/comment-page-1/#comment-63939

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