Is The Bond Market Reflecting ‘Normalcy’?

As market players there is an overabundance of items we have to consider before making a decision, no wonder analysis paralysis is often the result. As if the equity markets are not enough to think about we also have to understand where the bond market is positioned. I have always believed an efficient bond market always gets it right when it comes to pricing inflation and the health of the economy. The main factors of consideration are cash flow, return of principle and inflation.

Today we see the bond market is sanguine on inflation (which if they were worried about it would require higher yields and not lower), pricing in risk of lower global growth and perhaps a bout of deflation as it becomes a safety valve against the many uncertainties around the globe. Further, the Fed continues to be engage and is buying up bonds on the long end of the curve (10 yr maturities) while dumping shorter term (5 yr maturities) in the twist program (note: this was not an expansion of the Fed’s balance sheet).

But as you see in the chart below the current yield curve is shaped more normally than you would think, but clearly there is not much room left to the downside of yield before it flattens (below). A nice, upward sloping yield curve implies economic growth with little inflation. So, all is well according to the bond market? As Lee Corso of ESPN would say, ‘Not so fast my friend‘.

 

Now, we can scale this any way we want to make it look more normal or distorted but clearly we are in unfamiliar territory. It has been decades since we have seen all yields under 3% and if you blew up the scale to include more ‘normal’ long term yields of 5-7% or more (historical) then you would see a very flat curve (that was mostly compressed on the long end by the Fed’s twist program and prior QE’s.).

The normal yield curve – similar shape and convexity of the current one.

What a flat yield curve would look like – this portrays economic weakness is on the horizon and serves as a warning flag or caution. In a ‘normal’ world when inflation expectations rise we would see the Fed raising rates (short end) to combat coming inflation and/or bond holders selling the short end and buying longer dated treasuries to increase duration. However, is this where we are heading or are we already there? Even if we flatten out we are nowhere near the line below (middle of the scale) Interestingly, our best example of a flat yield curve near the bottom of the scale is Japan.

It has been argued that the bond market is in a massive bubble that is unsustainable over time. Of course it is! Will it eventually pop? Sure it will, but it won’t be glory if everyone is looking/waiting for it! Look, when too much money flows into an asset class (see chart) you are bound to create a bubble, but trying to guess when that ends has been futile. We can track back the origins of this bond bull market to the popping of the inflation bubble in the early 1980’s, and how has betting against bonds since then worked for you? The past 30 years have shown us so many uncertainties around the globe that require some safety in portfolios.

The fear of the unknown is directly correlated with the rise in bond prices. So, trying to get in front of that lengthy bull train has been a useless (and financially devastating) exercise in playing contrarian. In a complicated and uncertain world the choice of safety and stability can still be pointed this way, even if it’s just the US being the best house in a bad neighborhood. The dollar is showing strength vs other currencies and has outmatched gold in recent weeks.

Finally, I would say the European crisis has caused a capital flight to safety. The uncertainties in euro-land have had a profound effect of buying safety here in the US. We’ll see if that continues after some of these crises abate.

Let me know what you think, comments appreciated!

Bob Lang is the Senior Market Strategist for options trading newsletter Explosive Options