What the Bond Market is Telling Investors

Flattening Yield Curve   

The yield curve represents what investors are willing to accept by holding debt over short, intermediate and long-term periods. A typical yield curve is sloping upwards since longer term investors normally require a greater return to compensate for the risks of holding debt over many years. The extra return - referred to as the term premium - reflects the investor's view of future economic growth and inflation among other considerations.  A rising term premium reflects concerns over excess supply of debt, credit quality, and higher inflation in the future; a falling term premium has these factors moving in the other direction.  Over the past year or more, the term premium has fallen significantly, hence the fall in long-term rates. 

Changes in the slope of the yield curve signify changes in the economic outlook. Over the past few months, the yields on long-dated US Treasuries, 10 years and up, have fallen and, at the same time short term rates have moved up. These two developments are related. Short rates have moved up  in anticipation of the Fed increasing its overnight interest rate. Fed Chairperson, Janet Yellen, has spoken of the need to increase the policy rate in " the coming months" and other members of her committee have voiced similar views. In its most recent policy meeting, the FOMC continues to hold out the possibility for at least one or more rate increases before year's end.  At the same time, investors in the long end of the bond market are saying that any short rate increases will have a detrimental effect on economic growth and that any policy shift must weigh that consideration. In effect, the long end of the curve is saying: increase short rates at your ( Fed`s)  peril.

What can we learn from the recent behaviour of the yield curve? 

Low yields are a symptom of  economic malaise . Although there have been many criticisms of central bankers for introducing negative short interest rates, the central bankers are not responsible for the decline in long-term interest rates. Negative interest rates are not the problem. Slow growth and disinflation are driving longer rates to historic low levels. These bond yields are not the problem but are the symptom of widespread economic weakness that is not expected to improve over the next decade. 

Low inflationary expectations are well-entrenched. Clearly, the negative nominal and real rates of interest are sending a powerful signal that those economies are going to experience very low growth without inflation for the next 5 to 10 years. There is a well-entrenched view that inflation and growth will remain very subdued over the next decade.

Shortage of quality debt.There is growing evidence that quality debt remains in strong demand and highly sought-after. The decline in the term premium on long-dated government bonds demanded by institutional and central bank investors supports this assertion.

Long term rates to remain low. The combination of strong demand and supply restraints will keep long bond yields at these levels or even lower for many years. Any change in the current direction of bond yields will not come from within the market itself. Rather yields will rise only if governments resort to aggressive fiscal policies that promote growth and higher inflation. As yet, there is no sign of any policy shift in that direction, especially in the US and the EU.

Equities Vunerable - Fed's Monetary Policy Report 21-Jun

https://www.federalreserve.gov/monetarypolicy/files/20160621_mprfullreport.pdf

Zero Inflation

Looking at the docket going forward there is plenty of event risk. What lies most suited for a trade idea within FX? EURUSD. So much potential for so many reasons, although not necessarily well placed from a technical perspective.

- One of the largest lenders in Portugal has their shares halted on Thursday due to accounting uncertainties and a massive selloff.
a. sovereign aspect
b. financial aspect

Yields for European markets have seen yields drop extremely low. Capital has followed this demand, therefore propping up EUR. Yields more recently have picked up.

In the docket, we have ECB President Draghi in Parliament for the Quarterly hearing, Germany investor sentiment - ZEW (JUL), Eurozone Investor Sentiment - ZEW (JUL).

Targeted LTROs do increase balance sheet, and do have a negative impact on the Euro but we're looking for something more short term. Will Draghi mention something in the pipeline?

Interest rate expectations are pulled back for the US for when the Fed's first hike will come. Yellen will be giving her semi-annual testimony to the senate committee, this could help USD as long as she stays with the status quo. Known hawks Fisher and Bullard are also speaking. If interest rate forecasts pick up then there is potential for the USD to gain significantly.

China GDP figures this week, if weaker than expected, could also help to strengthen USD.

US catch up

US... til Friday 9th May
--- Only 72/500 S&P 500 are beating the index.
--- Last month US PMI Drops, Misses By Most In 8 Months
---Yellen – we will keep rates low.
--- Russell 2000 enters 10% correction near 6 month lows. Russell 2000 first close under 200 DMA since November 2012. DJIA back into red for the year.
--Considerable divergence in bonds means the curve is steepening modestly. Atrocious 30 Y bond auction, expected to price at 3.40, but priced at 3.44,bid to cover was the lowest since 2011.
-- Initial claims dropped 26k to 319k, beating expectations after last week’s spike.
--Strong 10 Year Auction Prices At Lowest Yield Since June 2013 despite 288k NFPs.
--Markets have shifted from the RMB into a USD funded carry trade with low US bond yields working as the catalyst
--NFPS did great! 288K vs 216K expectations. Unemployment rate 6.3% vs 6.6 exp.
--'All time high' is now a market condition: Box pulls IPO 'after a sudden weakening in demand for tech stocks'. ATH is not enough.  18 months ago the company could've got away without even a path to profitability.
--Unempl claims 319k 
-- Non manu PMI 55.2

Then... today... celebrating Donetsk Independence:
--Russell 2000 up 2.5% and +4% from Friday.
--Spike lower in VIX (below 12) and... of course USDJPY stop-run back through 102....
--So... DJIA and S&P hit ATH again. we await tomorrow for more exhuberance.
--T yields rose modestly (2-3bps)

US graph. Corporate profits surge.... what about employment?

Sprott on the greatest danger facing the world today. Thoughts?

Greatest danger facing the world today, according to Eric Sprott, a Canadian billionaire and Chairman of Sprott Asset Management:

“The biggest danger is that the financial system is over-levered. And perhaps at this point I might even mention one of the most ludicrous things I’ve ever seen. It was suggested by the Bank of England that should an important bank not be able to meet its derivative demands because it has a losing position, that claims on that bank be suspended - that entities wouldn’t be allowed to make a claim on those derivative losses. It’s like being in a fantasy land. You lose money but you are not allowed to claim from the guy because he could go down. Of course I know the reason they don’t want anybody to go down: ever since Lehman Brothers they’ve abandoned the word ‘liquidation’ because they saw what a liquidation could do. They don’t want any bank to start the liquidation process because that’s when we find out what things are really worth, and they are not going to be worth anything compared to what the banks have on the books. So the big time bomb is derivatives and leverage in the banking system. We keep getting these comments out of Europe that some country has got to raise $25 billion to boost the capital of the banks. This is in an environment where the paper assets have been allowed to appreciate. Imagine a situation where they start depreciating. The leverage is just way too high and to me that’s always been the lingering huge fear. We could throw in wars, continuing economic decline, which I think we are having, but a bank collapse would be by far the biggest item in terms of how it would affect the financial markets, and in particular in how it would just blow interest into the precious metals area".