Mr. Bond Decides to Die Another Day

An update on US fixed income instruments by TMM2 member 'Leftback'

This is another in our series of periodic updates on the status of our recent fixed income trades here at Falling Knife Capital Management. This weekend, our correspondent Leftback was relaxing in his homeland, which to his horror, has recently become the United Kingdom of Theresa May:UK Net Migration from where he reviewed a number of charts for US fixed income instruments and, as he reports here, despite the yammering in the mainstream media about inflation and “higher yields are coming”, recent trading has been peaceful, almost soporific - and the tone of many bond markets is now positive, almost bullish in fact, with traders taking every opportunity to “buy the dip”. Not many saw that coming, when we first mooted the idea of a tradable rally in bonds, back in early January Anatomy of a Bottom … or even in late January Buy The F/I Dip .

Avid readers of Macro Man will recall that in late November and December, we donned first the Kevlar gloves and then the full body armor in a bid to catch a variety of fixed income ETF instruments as they were reaching terminal velocity under the influence of the market’s often-invisible gravitational force.

In the process we became very long US fixed income [to the extent of 80% of the portfolio], with substantial positions in AGG, TLT, LQD as well as a closed end muni fund, IQI. Since then we have remained long all of these instruments, and have continued to monitor their performance, as well as the widely traded ETFs, MUB and BOND. As a side issue, we continue to monitor USDJPY, which became a proxy for risk assets in 2016, but has shown signs of weakness in 2017. In recent years, increased FX volatility (especially a stronger yen) has tended to precede moves to lower UST yields, and eventually we have seen declines in risk assets such as crude oil, other commodities such as copper and, yes, even US equities.

Suffice to say that fixed income trading has not been plain sailing in 2017. As is common for 007 in his line of work, BOND has been attacked by a series of would-be assassins in recent weeks. The long bond auctions and the February PPI and CPI data releases have all taken shots at BOND. Worst of all, the shadowy and sinister villain who inhabits the Eccles Building [The Woman who is known only as “Y”] has threatened BOND that each of her meetings with him are “live”, and that she will be seeing him in March. Y does tend to talk the talk a lot, though. One and all have tried to do their worst to BOND, in a seemingly non-stop succession of assaults, to the point where we would expect BOND to be not just on the ropes, but face-down down on the canvas, about to breathe his last, perhaps making a last call to Bill Gross to warn him to stock his yacht in Newport Beach and set sail into the sunset…

In fact, much to everyone’s surprise, BOND has refused to expire. BOND sits well above the December nadir, and rests on firm support provided by the 50 day moving average, having pulled back near to the 50dma on 2/1 and 2/15. The 20dma crossed over the 50dma some time ago, and BOND lies well above these levels this morning. Believe it or not, the 200dma is now in sight just 1% or so higher than Friday’s close. RSI is 65 and rising.

We know, of course, because we are constantly being told this by no less an authority than CNBC, (nicknamed “Tout TV” by the late great Alan Abelson), that “bonds are finished” and “yields are going higher”, but the fact is, punters, what you are looking at here are bullish chart indicators, and clearly, for the time being at least, 007 has decided to Die Another Day.

Don’t believe me? Check out the US curve, here: US Yield Data

Yields in the 5y are hovering below 2.00% and the 30y below 3.00%; even if one views this merely as movement within a trading range (which we do not), then the 10y seems to have been capped around 2.50%, and yields in the 30y around 3.10%. Those yields obviously compare favorably with the prevailing dividend yields currently associated with IWM, QQQ or SPY.

Here is a look at a 3-month chart, showing a series of higher lows and more recently higher highs in BOND:

After finding a bottom in December, the PIMCO ETF “BOND” eventually bounced and broke above the 20- and 50-day moving averages in the first few trading sessions of 2017 (1/2 – 1/5), but then pulled back, suffering a sharp reversal following the January long bond auctions. After a few days when BOND was clinging on to support, BOND finally closed on or very close to the 20 DMA on 1/19, dipped briefly below on 1/20, but then bounced back. The chart for BOND clearly shows a series of higher lows and higher highs over January, culminating in a short-term high on 1/12.

The subsequent price action in BOND was more challenging, although on the heels of a strong auction of US 3y on 2/7, BOND gapped open on 2/8 and rallied strongly into the rather weak auction of US 10y. Then came the series of assaults in mid-February, and subsequent trade saw a series of price dips (yield surges) early in the day followed by a slow steady slope higher in BOND (slow yield decline). Interesting…. it is almost as though there were a group of buyers waiting for each dip, and a fairly large group of shorts, slowly exiting the day trade, perhaps unconvinced that yields can break higher. No less a sage than Sir Jeff Gundlach has opined, no doubt with a wry smile, that Shorts May Get Squeezed Here. Gundlach Sees Yields Falling Below 2.25%

Price action in AGG has been broadly similar.

The trading trajectory for muni funds has also been strong with the technical picture softer of late, but still unequivocally positive for IQI and MUB since early December.

Our underlying rationale for entering the trades in medium-term US bonds can be summarized as follows: inflation is low, and it’s going to remain low. How so, with US equity markets seeming to make new all-time highs every five minutes and President Trump touting Yuuge Tax Cuts and to Make America’s (infrastructure) Great Again? We would argue that US wage inflation remains almost non-existent, the recent spike in oil prices will be transitory due to the continued global oil glut, and the “base effect” of last winter’s low oil prices is about to disappear from y/y inflation data. We therefore propose that the Fed is likely to hike only once this year, or at the most twice, and this bolsters our faith that the belly of the curve (5-7y) will not move beyond the 2% seen recently, and in fact may well move a lot lower than 1.5%. This explains the renewed bid for BOND.

Now what of the long end, where fear of the dread Duration doth reside? The most deeply oversold in December 2016 among the ETFs reviewed here were TLT and LQD, both vehicles expressing the market’s negative views late last year on longer duration debt. Despite plumbing the depths for longer than the shorter duration vehicles, and reaching a lower nadir following the US election, both US long duration IG and US Treasury bonds have actually found buyers since mid-December. The chart for LQD shows a fairly positive technical condition with LQD sitting on the 50dma. As Polemic once counseled us in the days of Team Macro Man Mark I, when the price of an instrument ceases falling on bad news, the market is telling you something. Just as markets top on good news, so they tend to turn upwards when bad news fails to depress prices further. Once there is no marginal trader left to sell, price will drift upwards and then all that remains is for shorts to cover….
Let’s look at the performance of long-term corporate bonds (LQD):

Below, that most-reviled of instruments, the Long Bond ETF, TLT:

TLT is less healthy but still well above the lows of December, despite an avalanche of bad news. Once again, the performance has been strong since early December. How can this be, when adding duration seems to be flying in the face of logic, the Fed and CNBC??? In a nutshell, we believe that the Fed isn’t actually going to reduce the size of the balance sheet significantly any time soon. Why do we believe this? We think this because Ben Bernanke, the architect of the policy, actually TOLD US SO. Many times, Big Ben informed the world that the Fed’s portfolio of USTs and MBS would simply be “held to maturity and allowed to run off” naturally, (a slow process that will take decades to complete). This balance sheet aspect of Fed policy affects the long end of the curve more than the short end, and we think this indicates that some degree of curve flattening will occur once more later in 2017, bringing the 10y perhaps to 2% or below and the 30y back to 2.5% or potentially much lower, as the prospects for the Trumpflation trades fade and an extremely large group of shorts are forced to cover. A full exposition of this position has been aired here: Trumpflation or Return of Deflation?

Similar views have been outlined in the past by Lacy Hunt, by Gary Shilling, and by others who remain firmly unconvinced that the bull market in bonds has in fact ended. Whether new lows in US yields remain to be experienced, or whether this moment merely represents a tradable bounce in US fixed income before the bear resumes (as Jeff Gundlach has suggested), we are not sure, and will remain agnostic for the time being. One of the best supporting arguments to be made concerning a move to lower yields in the US is that European and Japanese fixed income investors are starved for yield and remain desperate for both yield and safety. In this context, please note the recent move in bunds, and that the US-German spread remains wide. USTs therefore are very attractive, and this can be seen in the enthusiasm of foreign buyers at recent UST auctions.

One could go further, and suggest that the talk of higher bond yields on CNBC is just yet another example of “Fake News” from The Media, and punters should look at what happened to Swedish bonds* last night…





*Just kidding, folks. All is well in Scandy Land, at least until July 2017 and the next round of the Greek tragedy….?