The Bond Market: The Tail that is Wagging the Dog

A study done in 2011 showed the global bond market is nearly triple the size of global equities.  I am quite sure it is even bigger today, but according to McKinsey, in 2010 there were 212 trillion in capital stock and bonds made up 75% of that number.  Hence, the enormous size of the bond market gives heed to investors looking for safety and income, but are ultra-sensitive to changes in interest rates.  We see rates increase when inflation rises, but they decline or stay low when inflation is nascent, so inflation really is the ONLY reason to shed bonds.  Now, while the market controls the long end of the curve the Fed has control of the short end (fed funds futures, short term rates).

The Federal Reserve is all too aware of the bond market machinations, and it has often done the Fed’s work for it in front of a policy change.  There is enormous paranoia in bond investment land, obviously when you see the enormity of the size.  A small tick up in inflation could be worth several billions in losses.  That is not even mentioning the eight trillion in debt held by the US, where vulnerabilities are heavy.

Back to the bond market.  In the early 2000’s I worked with many bond traders at Countrywide Capital Markets.  These were some of the smartest traders who boasted clients with some of the biggest funds around, but at the same time they were extremely paranoid.   The big joke that is always passed around, bond investors are so paranoid they have predicted seven of the last two recessions.

Yet, there is a diversion between what the bond market sees on the economic horizon and what the Fed would like to have happen.  Bond yields continue to decline, money shifting out of equities and commodities.  If we were to believe the bond market, there will be no RATE HIKE in 2015 and a normalized curve may not be seen for three years or more.  See the link for Fed Funds Futures below, there is an implied probability of about 24% chance of a 25bps hike in Sept, yet they could move smaller – about a 65% chance of a 10bps hike at the Sept meeting.  December sees about an 80% chance of a 25bps hike while January 2016 is fully-price.   If the Fed raises rates, even in a slow cycle then there should be ‘implied’ inflation threats coming from the economy.

Fed Funds Futures

Again, the bond market is not seeing it – and all the rhetoric won’t change the data.  There is no mistaking the Fed would like to get off zero interest rate policy (ZIRP).  Chair Yellen and others on the committee have been quite vocal about their desire, but they must listen and respond to the bond market, otherwise the curve gets completely out of whack.  So far, the yield curve – while flattened out – is NOT portraying a recession is coming down the line.   But, the tail is wagging the dog here, the risk is high if policy is changed at a time when the economy could be at risk.