THE BATTLE BETWEEN NERVOUS 'HAVEN FLOWS' AND 'BOND BEARS'

On September 24th, Global Macro Monitor  posted a 5,000 plus word tome,  The Gathering Storm In The Treasury Market, the very day the S&P500 peaked at 2940.91, its all-time high.

The yield on the 10-year Treasury soon broke out to 3.25 percent, a level not seen since 2011, which, as the chart below illustrates, broke the stock market.

I have excerpted some salient points from the research that possibly mean more today than then.

SUMMARY

  • We believe the market is way off base in its analysis of what caused stocks to sell hard in 2018
  • The U.S. and world have a debt problem and yields need to mover higher in order for markets to clear
  • The breakout in long-term yields in late September broke the U.S. stock market
  • The macro factors that caused the stock market collapse, the changing dynamics in the Treasury market,  have not changed and are likely to deteriorate further
  • A volatile future is highly likely
  • Timing to be determined

In addition to the massive increase in the supply of  Treasury securities hitting the market,  we noted several structural factors on the demand side that are changing.

  • The massive borrowing by the U.S. Treasury is crowding out emerging market capital flows
  • The structural factors that have kept long-term interest rates low and term premia repressed are fading
  • The U.S. budget deficit is exploding
  • The Treasury has to increase its market borrowing as the Fed rolls off its SOMA Treasury portfolio
  • Social security has moved into deficit and borrowing from its trust funds to finance on-budget deficits is over
  • Globalization is under threat, and foreign capital flows into the U.S., particularly the Treasury market, are declining  – GMM,  September 24, 2018

Haven Flows And Bond Bears Pile Into Treasuries

As stocks collapsed, haven flows did swamp the negative structural factors, as expected.  In addition, the global macro stock bears piled into bonds as their instrument of choice to get short stocks, driving the 10-year yield down to 2.55 percent on the second trading day of the year.

CONCLUSION

Mr. Market Can Stand Many Things, But Can’t Stand Higher 10-Year Yields 

Given the unprecedented increase in Treasury supply during an economic expansion, coupled with the changing structural demand factors we cited, we concluded a move to over 4 percent and quickly was a done deal.  Unless however,

All bets off given a geopolitical shock — we are concerned how quickly U.S.-China relations are moving south;  a collapse in stock prices,  or a sharp slowdown in economic activity.   Haven flows will likely swamp the structural factors pressuring  yields higher.  – GMM, September 24, 2018

We are beginning to suspect the global markets are experiencing an evolving epiphany that the world has a debt problem and real yields need to go higher for the Treasury market to clear. 

However, because of the extremely elevated level of asset prices, including stocks and housing, fundamental valuation (discounted cash flows) dictates that prices must move lower with higher interest rates.

In our “new economy” which is so dependent on asset prices — go no further than the beating Jay Powell just took — we are not so sure the bond market can clear at a much higher equilibrium real yield.

If that’s the case, then as, or if,  markets grow more confident, stock bears sell their bonds, and the haven flows continue to move out of Treasuries and back into risk assets, yields should move much higher and faster than expected.

Up to a tipping point level where asset markets sell-off hard again.

Too much debt has become the asset markets’ governor.

The Treasury may only be able to fully finance the shortfall in demand from natural buyers with haven flows.   Ergo softer risk markets.