Bond Bubble Is Here

Mother's Little Helper portfolio was DOWN today -$538.90 (+0.45%)

Overall GAIN YTD: +$2,149.37 (+1.83%).

Our benchmark index, the S&P 500 is DOWN Year-To-Date (+1.47%)

http://money.cnn.com/data/markets/sandp/

"“This would be a great world to dance in if we didn’t have to pay the fiddler."

- Will Rogers

I made my buys for the year on December 28, 2017, see the new portfolio here (Click Here).

  • The Fed controls short term interest rates; rates are rising

  • The market controls long term interest rates; rates are rising

  • Foreign investors use dollars to hedge long term treasury buying; There is a dollar shortage in foreign markets; dollar shortage increases cost of hedging

  • Selling pressure on US 10-year will accelerate as overseas treasuries look more attractive

I’ve never rung the alarm bell when it comes to investing. During the financial crisis I’m certain I said, “This too shall pass”, quoting my father, a Shearson branch manager with almost 50 years in the business. Today I’m giving the bell one good whack, I hope someone is listening because a lot of people could get hurt if they ignore what's happening in the bond market.

Background

Two years ago I was spouting off to anyone who would listen that the U.S Bond market was in a bubble, that the bubble was unsustainable and that in the near future we are going to see bond prices collapse as bond yields rise. The reciprocation of that time is that I got invited to fewer parties. As a student of history I'll walk us all through the milestones that got my thinking to the current position I hold.

October 2016

Back in October 2016 The World Economic Forum was talking about the return of a dollar shortage. https://www.weforum.org/agenda/2016/10/a-dollar-shortage-has-returned-this-is-why. Dollar Shortage was a term coined in the post-world war II era where Europe and Japan struggled to rebuild because access to the liquidity of US Dollars was very difficult; The Marshall Plan in part helped alleviate this issue. We saw the term show up again in 2008 during the financial crisis. The problem today is that we don’t have anything resembling the Marshall Plan and rates are so low that there isn’t much room for the Fed to do what they did in 2008.

February 15, 2017

On February 15, 2017 I wrote a post that recommended on Day 43: Buy Bond Market Equivalents https://www.claybaker.com/single-post/2017/02/15/Day-43-Buy-Bond-Market-Equivalents. My rational was that these stocks paid a better dividend and they had the opportunity to appreciate in value. My primary concern at the time was that no one should lock up their money in low yielding bonds if interest rates were going to keep rising.

May 2017

In May 2017 The Financial Times rung the warning bell of The Dollar Shortage, its effects on emerging markets and holders of fixed income instruments (Bonds) and the stock market. https://www.ft.com/content/4ea2e24c-30b2-11e7-9555-23ef563ecf9a

August 4th 2017

Last year I started writing this blog. Fearing the same retribution I avoided the topic of bonds until August 4th 2017, my birthday. For my birthday I decided to write the post titled “Bond Market Bubble”? https://www.claybaker.com/single-post/2017/08/04/Day-220-Bond-Bubble. While the post was well read I don’t recall getting the flood of emails I get around a stock pick or some of my wilder prognostications.

December 2017

In December 2017 Blomberg published a piece stating that The Dollar Shortage is here, it’s real but don’t worry, it’s temporary. A 4 year slide is not temporary, that’s a trend. https://www.bloomberg.com/news/articles/2017-12-21/this-dollar-shortage-isn-t-likely-to-last

While the article’s author did some good research, what wasn’t asked is what happens to holders of long duration bonds as this Dollar Shortage progresses, rates rise and bond prices continue to decline. That’s a really important question, especially for readers of this blog who might be depending on bonds for current income.

January 13th 2018

On January 13th 2018 I wrote the post, “Shorting US Bonds”. https://www.claybaker.com/single-post/2018/01/13/Shorting-US-Bonds. No ‘click-bate’ question mark after the title, no discussion with my readers, I simply did it. Why, because I felt the bubble was about the strain and that soon we would see a dramatic shift in the bond market. My action at the time was to buy shares in the TBT (ProShares UltraShort 20+ Year Treasury), as bond price come down the TBT goes up, it’s a hedge against falling bond prices or rising yields however you like to view it.

March 2018: Alan Greenspan agrees and says we're in a bond market bubble https://www.cnbc.com/2018/03/01/ex-fed-chair-greenspan-we-are-in-a-bond-market-bubble.html

What I think Will Happen

The Fed will keep raising rates as the U.S Economy continues to expand and grow. Given the anemic growth we had from 2009-2016 and the dramatic growth of the last few quarters I suspect that we are in the 4th or 5th inning of a 9 inning game. Said plainly, rates are going higher for a long time to come. Higher rates indicate a strong economy, things are good. But there is a negative side and this time around we have a really unusual negative side. All the Quantitative Easing that was done to alleviate the financial crisis loaded up the Fed’s balance sheet to the tune of $4.5 trillion in bonds and mortgage backed securities. Now we are going into a period of ‘Quantitative Tightening’; the Fed has to unwind all that debt. In fact I wrote a post about this debt last year claiming that it isn’t possible for the Fed to get rid of the debt for all the reasons I’m citing here. It’s really going to wreak havoc on markets.

This is all happening at a time when we have robust growth requiring higher rates to keep inflation in check, we’ve printed more money than at any time in history (https://fred.stlouisfed.org/series/M1) and rates are lower than we’ve seen them is many years. As the dollar strengthens and the Fed unwinds its balance sheet, foreign governments will find it more and more expensive to use dollars to hedge, and our bonds will simply become unattractive. The higher cost of hedging reduces the value of the bonds. Imagine buying a car and the insurance on the car costs more than the car is worth. But those governments have to stay liquid and they have to hedge their imports and exports; China will most likely step in to fulfill that role and we’ll begin to see the U.S Dollar get supplanted by the Chinese yuan as the preferred currency of international trade. The U.S has made the transition from the largest creditor nation in history to the largest debtor nation in history. The next century belongs to China.

What Can You Do?