Three Little Bids

I have often said the market does the thing that makes the most people wrong. It doesn't mean that the market is always right, though.

The U.S. bond market seems to be signaling a slowdown that is nowhere in sight, as 10 yr yields have dropped to three-month lows. With all the inflation talk, you may be surprised by this, but I am not. The positioning in the bond market has increasingly been getting short, reflecting growing anticipations of a reversal of the Fed's easing policies and a rebound in inflation. But central bankers are in control of the narrative like never before, as they experiment with a new reaction function to economic data. So like it or not, they are creating a disconnect between the price discovery in fixed income and the incoming inflation signals.

To a large degree, the recent decline in the yield of longer-dated Treasuries is more noise than signal. As we sit here in early June, there are three sources of demand for fixed income that explain this seeming inconsistency, and they are all related. Quantitative easing programs continue apace, siphoning $120B from markets every month despite the prospects of a full economic recovery thanks to the vaccines. If the market is convinced, as it seems now to be, that the Fed will be comfortable staying behind the curve, prices will be distorted. Because there is a large buyer on the market, other market participants are forced to act accordingly. The Fed is 'bid one'.

The 'rebalancing' bid is now strengthening into the quarter-end. There is a mechanistic bid to low-risk assets from pensions and advised funds who are getting increasingly uncomfortable with their high levels of equity exposure. Automatic demand for bonds. 'Bid two'.

Bid three is somewhat more opaque and harder to quantify. When you have a saving glut it has to go somewhere. In normal recoveries during prior recessions, consumer balance sheets were in dire need of repair. People dip into their savings and come into the early stage of recovery with little financial firepower. Thanks to the largess of governments who threw money at the system last year, that isn't the case. The savings rate has soared and with it, the assets of consumers, desperate to find a safe home for their cash. Bond yields in the long end as low as they are, still have attraction relative to bank accounts that yield nothing.

A segmentation of the demand for financial assets has developed. Aging baby boomers who have spent years accumulating savings, and having experienced large drawdowns in the past, are unlikely to bet the farm on a stock market that has been perceived to be overbought for most of the last 14 months. The 'V' shape of the stock market left many in the dust, waiting for a correction that has yet to materialize. Meantime they continue to buy fixed income. Bonds can stay mispriced for longer than you can stay solvent, Mr. Bond Bear.

So I don't believe that this seeming disconnect between the messages of the bond market and stock market are anything more than a 'technicality' induced by the Fed and risk appetitie. But that's what they want. After the rebuking they took in 2018 - a mini-taper tantrum in the fourth quarter - they have decided to err on the side of excessive stimulus. Perhaps it reflects their belief that secular deflationary forces of slowing demographic and technological change have their back. I have been giving those elements acknowledgment in my recent blogs.

As well, the rate of change at the margin for economic data is likely peaking as we speak. The second derivative of growth is turning negative, and that's what drives expectations. By year-end, when the 'transitory' effects of supply chain shortages have been fixed, we should have a better read on the real inflation rate that will form expectations for fixed income prices. Expectations for 2022 are now starting to drop, offsetting current inflation fears. Higher taxes and labour cost rigidities are adding to potential threats to equity dominance over bonds.

As we get closer to August when the Fed is anticipated to confirm their tapering intentions at Jackson Hole, watch for a flattening curve to develop, as the 2 to 5-year yields rise sharply against a 10-year yield anchored somewhere between 1.75 to 2.0%. Can you say 'volatility'?

Meanwhile, the three little bids are enough to support markets that are now priced for perfection. The Fed has executed flawlessly on a strategy of keeping bond bear vigilantism from getting the upper hand. The performance pressure on managers is likely to keep asset prices elevated for now. Nobody will be surprised when they start to talk about the dreaded tapering of QE. There will be no tantrum this time. They have stayed dovish far longer than even the most optimistic forecaster dreamed. Their communication strategy has worked to perfection as we exit the recession with permanently lower yields. Let's give them credit for cleverly negotiating the trickiest economic downturn in history. I'm not so certain about the rest of the decade to come, but that's a topic for another day.

So I don't believe the 'right' price for 10-year fixed income securities is anywhere close to 1.5%. But that doesn't matter when the markets are being controlled by Jerome Powell.

This is my message to you-who-who. With three little bids - every 'ting gonna be alright!

Risk Model: 2/5 - Risk Off

Only a complacent VXV and an optimistic AAII are in positive mode currently. The threat to the market is a temporary counter-trend downshift in growth expectations for the forward 12 months. With the headlines screaming "inflation" and "roaring 20's", the Copper/Gold ratio is quietly disagreeing. This has the contrarian in me interested. Even with the threat of strike action in Chile and higher taxes in Peru, copper is rolling over as gold catches a bid. As I said last week, this bears watching as the quarterly window dressing effects start to wane.

Sell in June and wait for a swoon is looking good here. This should disadvantage 'value' more than 'growth' strategies. If the market starts to believe that the Fed has started the meter ticking on the removal of QE, we could actually have more risk here than we think in the cheaper parts of the market. They are more sensitive to a change in economic growth expectations. Flattening yield curves won't help financials. Talk of a commodity super-cycle should fade as well.

But don't forget to buy the dip.