This will be my last article for a few months as I go off the grid for some work stuff until the spring. Before I head out, I wanted to write about the upcoming year and how I see the bond market playing out in 2018.
As Mark Spitznagel pointed out in The Dao of Capital, the key is to see the forest in the pinecone. Most folks can see the pinecones on the tree, see the trees in the forest, and some can even see the forest - but seeing the forest in the pinecone is the challenge macro investors face. I think the biggest challenge facing the macro community today is seeing the breakdown of bond markets developing before the break occurs (the forest in the pinecone). To me the signs are apparent and are growing by the day.
There is a lot of debate about inflation and yields - and lately, the yield curve. Wall St tends to see rates rising each year only to be Charlie Brown'd most of the time. With that said, I never sense too much risk being put on higher rate investing. So even when Wall St expects rates to rise, they expect it to be gentle and benign. Don't believe me - look at the Street's forecasts for asset prices. We hear some cries of inflation from time to time but again, the money seems to always be firmly betting on it staying lower for longer and any rise to be gentle and benign. The Fed sees no inflation coming and market participants can only imagine a small spurt of cyclical inflation thanks to oil prices firming up lately. Many think the Philips Curve is dead or that it does not matter anyway because of debt and demographics and technology etc.
What do I see? I see a setup for 2018 to be the year the bond bull that has lasted my entire lifetime (I am 34) coming to an end. I can see inflation surprising to the upside and surprising the Fed, the economics profession, and of course investors. I'm not calling for 70s style inflation, just for inflation to genuinely surprise the markets and the central bankers who try to control them later this year and into 2019.
Why? For one, because nobody thinks it can happen. The inertia of the long cycle of the bond market has rocked everyone to sleep. I mean honestly, why would anyone be a genuine bond bear or inflationista after the past generation of the trend being a one way street. There are like three guys on Wall Street that remember what rising rates are like and they drive rascals and get discounts at Denny's. Of course nobody sees this coming. The only people that will are people who have not already been wrong about it ten times and thrown in the towel.
So what are the signs that this could happen and happen soon. First and foremost for me is momentum. If you do not follow the work of the Olivers at Momentum Structural Analysis...you should. Their work shows the potential for a major breakdown in momentum for the bond market (and not just in the US) as soon as 2018.
Price is obviously showing signs of a possible break. If the 10 yr finishes the year here the trend is over. I expect the trend to not only die but yields to end the year around 3% if not higher.
So what will cause this secular shift to start in 2018? I see this game changing shift in the bond market as a soup and the ingredients are past CB extremism, the death of that extremism with CBs turning off the liquidity tidal wave, hot real economies, zero fiscal restraint, and of course inflation.
Central banks have been extremely aggressive over the past decade and while that extremism is now fading into the rear view mirror, the actions have placed a lot of dead wood throughout the forest that only needs a spark to start a fire. We tend to be forward looking for catalysts but should not neglect viewing the past decade as a precondition for those catalysts to burn the bond market down. The last decade of ZIRP, NIRP, and asset purchases globally have created a future fire that has just not burned yet. Whether it is nominal yields, real yields, spreads between "risk free" bonds and dumpster fire bonds, or yield curves - the distortions are right in front of our eyes. These distortions are the dead wood and they will burn. There is a $1.5 trillion swing in central bank flow coming up in the G4 and if you think bonds stay bid in that environment - please leave a comment with your thoughts because I struggle with this idea. QE pushed rates up in the past and watched them fall after because markets thought QE would work and create inflation (hell plenty thought hyperinflation). Now nobody thinks QE causes inflation but still do not see it's withdrawal causing inflation - if that perception changes - rates could explode without CBs realizing how or why. If I am right that tightening can help create inflation (if not overly aggressive and it won't be) - and markets figure this out - everything changes.
My second ingredient in my soup is the death of central bank extremism.
That chart sums it up. Economists and markets were dead wrong about low rates and QE and their effects on inflation (led to lower inflation) and I think it is quite possible that reversing those policies leads to higher inflation. The yield curve has gained a lot of attention lately. To me this is pretty simple really - the Fed is raising rates while global central banks have capped yields on the long end by buying every long bond being created and more - and essentially nobody thinks any real inflation is on the horizon. This is all an obvious recipe for a flattening yield curve...until it isn't. Kevin Muir has been outspoken about putting on a steepener (Raoul Pal and Kyle Bass discussed likely steepening on Real Vision as well) and these guys have been dead wrong thus far and may continue to be for a few months - but when CBs stop buying all of these long bonds, inflation surprises, and global growth stays hot - the steepener will pay off in a big way (this will actually be the recession signal as it usually is). I hope Kev keeps that trade on and profits from it. I have not put it on yet and will not until the ECB and BOJ start to actually tighten in a real way and inflation starts to shock markets a bit.
Another ingredient is a hot global economy. Asset prices globally are spiking as are real economies. We are seeing textbook late cycle moves in commodities while labor markets tighten, inflation picks up, trade firms up, and overall economic health and growth is looking robust and surprising to the upside (while CBs are still waging monetary jihad as if we were in a global depression). This global growth will lead to wage pressure (even Japan is seeing wages and prices pick up), inflation, and nominal rates picking up. The central bankers we are currently blessed with are more scarred by 08 than investors and cannot bring themselves to end emergency policy. I expect most of the CBs to stay behind the curve and allow hot inflation and economies to "catch up" for lost time and to help their governments lighten their painful debt loads. The US cannot allow real rates to go anywhere without creating a crisis and so the Fed will stay behind the curve by design. With that said, as they back away from bond buying, rates should naturally move higher as bond supply rises, demand falls, credit risk comes back, and inflation premium demand higher yields. Bond bulls like to say debt is high so yields will stay low...but not if CBs stay behind the curve on purpose and let cycles run longer and hotter all while fiscal restraint becomes a thing of the past due to politicians taking advantage of low rates and the fact that the public cares more about Trump tweets and Kim K's beef with Miss Swift than the national debt. Our new Fed Chair admitted not wanting to invert the yield curve. These guys know damn well every recession happens when they tighten policy and these days recessions are unacceptable it seems. I expect policy to tighten but to stay behind the curve as has been the case so far (see financial conditions). I believe the Fed is dying to allow inflation to run hot to smooth out the past few years of low inflation and ease the debt burden. Just as so few investors are still around from a bond bear market - there are also no CBs around who know what real inflation and the dangers it possess look or feel like. The false confidence in their ability to control inflation will be tested. For the past generation, a few little rate hikes killed inflation, so why not let it run hot when you think you can just kill it with a 100 bps of hikes. As you can see...the hot economy is begging yields to rise.
One thing I keep a close eye on for rising inflation and rates is the performance of industrial commodities and copper is exploding. In my experience global growth, commodity price increases, etc have all been met with extreme pessimism. Most do not seem to believe this is real or sustainable or inflationary in any real sense - and I think yields and spreads reflect this. I just think markets have this wrong and we will see rates rise and curves steepen.
Next up is zero fiscal restraint. The US economy is at or near full employment, growing for the past decade (will challenge for longest expansion in the modern era), picking up steam as asset prices gain shocking momentum (stocks up every month for 14 months and all of 2017) - and yet we just passed tax cuts that drain revenue and speed growth up - without paying for the new dent in the budget. Add to this the possibility of an infrastructure plan and a President that has never even pretended to care about the debt and deficit - you start to see a scenario where treasury issuance may get extreme. There is absolutely zero political energy expended on the debt/deficit right now and when you give politicians that environment - they will use it. DC, Wall St, and Main Street could all care less about this issue, so I expect the deficit to keep widening and treasury issuance to keep growing. This coupled with higher inflation, a tightening but behind the curve Fed, and price action changing trends will lead to a bond market shift most of us have never witnessed. If the BOJ and ECB and PBOC stayed really easy the Fed could keep getting away with slowly tightening but as they start to join the tightening party, I struggle to see yields staying range bound. Issuance is about to go up and I think these estimates below may be conservative.
Lastly I expect inflation to pick up and surprise the markets and it's overlords as well.
For one thing...nobody expects any real inflation.
Agricultural commodities have been brutalized and if they pick up and join energy and metals, our flawed inflation measures may start to sniff out significant inflationary pressures. I personally think ags are bottoming and will begin to add to CPI instead of helping to keep it pinned down. With that said PPIs have been running hot globally and the US is no exception, running multi-year highs.
Here are some more charts and tweets that I find interesting:
10 and 30 Year Breakevens via Jason Polansky who is my TIPS watcher on twitter.
Wage pressures have been hitting earnings calls and soft data but are yet to really show in the hard data - but they will.
Then this chart from Teddy Vallee
I want to leave you with one thought. A lot of really smart people think sure - yields may back up but when the real economy struggles the Fed comes back with the QE machine and yields make a new low. This very well may be the case and I used to think this exact thing. However, what if *this time* the market perceives the fireman's hose as containing gasoline? Because it does.
Have you ever asked yourself what if QE did not keep yields down next time? How does QE effect bonds if inflation is running at 3%? What if the enormous bid from China, Japan, Saudi Arabia etc vanishes?
Maybe I am wrong and the bond bull stays firmly intact and this is all years away. With that said, I am betting on the bond market breaking down this year. I have been long commodities and short bonds and will stay that way in 2018.
I leave you with a chart from my entire lifetime of 10 year futures.