Long bonds are past their best

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

Over the last few days, ar­ti­cle af­ter ar­ti­cle have been say­ing that this year’s de­cline in US long term rates was to­tally un­ex­pected, and that the be­hav­iour of the bond mar­ket has prompted many fi­nan­cial firms, and even the US Federal Re­serve, to throw away the econo­met­ric mod­els they used to fore­cast long rates.

Throw­ing away econo­met­ric mod­els and re­al­is­ing that mak­ing ac­cu­rate fore­casts with any de­gree of con­sis­tency is im­pos­si­ble—just look at the Fed’s fore­casts for the US econ­omy over the last few years—has to be a step in the right di­rec­tion. At the be­gin­ning of this year, the con­sen­sus was overwhelming that long rates had only one way to go: up. Out of 68 econ­o­mists polled by Bloomberg on the fu­ture be­hav­iour of long rates, all 68 pre­dicted a rise. Now, when­ever 100% of econ­o­mists ex­pect some­thing to hap­pen, alarm bells should sound alert­ing you that the ex­act op­po­site is about to hap­pen. Sure enough, it did.

How­ever, in a se­ries of re­search notes since Septem­ber last year an­a­lysts have ad­vo­cated buy­ing long US trea­sury bonds as a hedge against US eq­ui­ties.

The real en­emy of the bond mar­ket is in­fla­tion. Ac­cord­ing to Wick­sel­lian re­search, when­ever the cost of money for the pri­vate sec­tor is more than 200bp higher than the growth rate of US GDP, then the US in­fla­tion rate goes on to fall. The rea­son is sim­ple enough: when the cost of money is more than 200bp higher than the growth rate of the econ­omy, it does not pay to bor­row. The ve­loc­ity of money falls, and with it the in­fla­tion rate.

Now, let’s look at the be­hav­iour of the bond mar­ket it­self. If bond yields are up by 30% or more over the pre­vi­ous 12 months, then the bond mar­ket is over­sold and one should ex­pect a “re­flex” rally.

The first con­di­tion was met in Septem­ber 2013, with the real rate on long-dated in­dus­trial Baa bonds go­ing on to reach a peak of 240bp over GDP growth. The sec­ond con­di­tion was met at the end of Au­gust 2013.

Ev­ery re­ces­sion since 1960 oc­curred when the Baa bond rate was 250bp or more above the GDP growth rate. We came within a whisker of that point over the last few months-which, along with the win­try weather, may help to ex­plain why the US econ­omy con­tracted at a 1% an­nu­alised rate in the first quar­ter of this year-but we never reached it (while all re­ces­sions have oc­curred with the Wick­sel­lian spread above 250bp, not ev­ery oc­ca­sion when the spread has sur­passed the thresh­old has led to a re­ces­sion).

So, from Septem­ber 2013 to Jan­uary 2014, we had a very at­trac­tively priced long bond, which was also very over­sold. As a re­sult, we is­sued a buy rec­om­men­da­tion.

Where are we to­day? In a neu­tral po­si­tion. Baa bond yields have de­clined to a point where the spread be­tween the bond rate and GDP growth is be­low 200bp-at 110bp-and the bond mar­ket is nei­ther over­sold nor over­bought. Bond pro­tec­tion would make sense in your port­fo­lio if we were head­ing into a re­ces­sion, but that seems un­likely given the low Baa rate. How­ever, own­ing bonds could still have some merit on a val­u­a­tion ba­sis and as a hedge against dis­tur­bances in an overex­cited stock mar­ket.

But the time to load up on long bonds was in the fourth quar­ter of 2013.

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