Someone's been dealing out the happy pills over the weekend...

Monday 24th October 2016

Someone's been dealing out the happy pills over the weekend ..... but not to everyone.

ref:- "European Bonds Rally as Political, Economic Risks Diminish", Bloomberg Markets

and

ref:-  "Most Crowded Trade in Bonds Is a Powder Keg Ready to Blow", Bloomberg Markets

Two pieces from Bloomberg and there's a notable contrast in tone between them. The first is a simple market report on the buoyant mood in European bonds this morning, the second examines why two major money managers and bond market gurus are taking an altogether different view on the broader prospects for long bonds.

Frankly, the title of the first article seems to draw a pretty big conclusion from various pieces of information that may or may not linger in the memory. For example, there are numerous Federal Reserve officials lining up to speak over the next 24/48 hrs and any one of them is capable of changing the prevailing market sentiment all on their own. But market players will take direction where they can find it, and in the absence of any significantly contrary news  they have been encouraged this morning by a happy confluence of supportive reports both political and economic in nature.

Because sovereign bond markets are so closely correlated these days, good news for one is almost bound to have bullish spill-over effects on others. Certainly that's the case when long-standing worries in three different areas of the Eurozone seem to have reached some kind of resolution at the same time. Because we're talking about the market's immediate reactions to developments, we don't have to ask whether we are confident that we witnessing permanent solutions to difficult issues (in at least two of the three, we're not !). Rather, we can just take a look at what has given European bonds a lift this morning after a troubled few weeks.

Remembering bonds prices and bond yields move inversely,

SPAIN: Spanish 10yr Government Bond yields drop 5 basis points to 1.07 after news that Spain, after a period of electoral deadlock lasting the best part of a year, is finally going to get a government again. Acting PM Mariano Rajoy of the PP party will get the chance to take office for the second time as leader of a minority centre-right coalition after (most of ) the socialist opposition PSOE party agreed to abstain in a confidence vote. Almost any government except a hard-left coalition would have been good for markets, and in the past Rajoy has shown the kind of tough stance on fiscal matters that bond markets like. Of course, it all leaves the PSOE divided and unlikely to be able to act as the main rallying point of those politically left of centre. That could mean more support for the anti-austerity, hard-left Podemos party which would be decidedly market-unfriendly ..... but that's a consideration for another day.

PORTUGAL: Just a short while ago we spoke of how Portugal's debt had managed to retain "investment grade" status at DBRS, the last of the relevant ratings agencies to accord them that level. Well, it must have been a close call but they've done it again and crucial it is too. Without that status, Portugal's debt would not be eligible for purchases by the ECB's quantitative easing programme. That would be pretty disastrous not only for Portugal , but the economic disintegration that would likely ensue in that country might present the Eurozone with a new Greece-type issue on its Western edge. The yield on Portugal's 10yr bonds fell 9 basis points to 3.10%, the lowest in six weeks

FRANCE: Talking of ratings, S & P revised its outlook for France from "negative" to "stable", saying that the downside risks that had been identified two years ago had "failed to materialise". France 10yr yields down 2bp, at 0.26%

Throw in some decent budget deficit numbers in the Eurozone and a change in mood that has caused the chatter to switch from the subject of HOW the ECB will taper their QE programme when appropriate, to how it will probably be extended by six months anyway, and you've got the ingredients for a healthy opening this Monday morning.

Does it signify any more than that?

Er, probably not ..... and definitely not if you're Kathleen Gaffney of Eaton Vance Corp. who oversee $343 billion, or Brian Whalen of TCW Group Inc. who look after £175 billion in fixed-income assets. They take the view that the remarkable surge in long bond prices (and fall in yields) that we've seen in recent years and particularly in 2016 is over .... or soon will be. Ultra-low rates and massive central bank purchases have meant that owning bonds has been a sure-fire bet. But the argument being put forward is that not only have too many investors got one side of this market expecting nothing to change, but the signs are there that change is happening already.

Inflation, that scourge of long bond markets, is a growing force ...... particularly in the States where Treasuries are the global bond market leader and in the UK which is likely to suffer some hefty rises in inflation (by recent standards) due to its tumbling currency. Indications from the central banks that they would be prepared to let inflation exceed their targets pro-tem rather than jeopardise economic growth by a premature rate hike only exacerbate the situation. Excessive inflation is of more concern to bond investors than keeping short-term rates low.

Bond professionals study "Duration"  --  in essence, Duration is a measure of the sensitivity of the price  --  the value of the principal  --  of a fixed-income investment to a change in interest rates .... and the bigger the duration, the greater the interest-rate risk or reward for bond prices (Investopedia).

Suffice to say, duration at the long end of the bond market is extremely high. Consider this:

According to data compiled by Bloomberg and Bank Of America Corp., about $6 trillion is invested in global government bond markets of over 10yrs maturity. At current levels, a one percentage point rise in interest rates would equate to $2.1 trillion in losses for investors. Could it happen? It could ..... and moves of the magnitude of yield-swing are not even particularly rare  --  they've happened 10 times in the last 40 years. Or, as Bloomberg point out, twice as often as 10% falls in the S & P Index.

If that's going to trouble your sleep at night, don't worry .... it's not a majority view. But it might be worth remembering two things: nothing is a guaranteed one-way bet, certainly not forever ..... and it might be worth reducing your "duration".