Via the excellent Damien Boey at Credit Suisse:
Overnight, the Fed announced it will be increasing its repo size to $1 trillion per week, while the ECB announced more liquidity management and asset purchase measures (refraining from cutting rates into more negative territory). Yet despite all of this massaging, bond yields rose into the close, and are rising in the Asian time zone. What has caused central bankers to behave the way they have? And why aren’t bond yields falling in response to the measures announced?
The issues are that volatility in the bond market is now at very high levels, and illiquidity is becoming a major problem. These factors are causing some highly perverse pricing distortions across the fixed income complex, and general upward pressure on bond yields, causing the Fed to consider stepping in. But there are question marks about whether the Fed’s balance sheet expansion is the right way to manage illiquidity in the system. Some commentators are suggesting more nuanced measures such as debt buybacks instead. Our issue is that risk parity investors are now pretty much all in on bonds, at just the wrong time, when bonds are experiencing the sharpest delta in risk profile of all the major asset classes. The concentration of risk is resulting from de-risking behaviour to date, while the increase in bond volatility is resulting from:
- Reflation risk from fiscal stimulus.
- The improving profile of expected returns in alternative asset classes to bonds, and the overvalued starting point for bonds.
- General illiquidity.
- The lingering effects of heightened oil price volatility on inflation expectations embedded in bonds.
In short, anyone who thinks that bonds, and related exposures are safe ought to think again. There is no worse place to hide than in bonds right now.
We reiterate our view that it is the wrong response from the Fed to try to save risk parity and passive investors, because this task is almost impossible. There has been no diversification in these portfolios on the way down, and there is no diversification on the way up. Better to let the losses fall where they lie, and pick up the pieces later. Instead, what we have is the Fed and other central banks using up all their limited ammunition against a force of nature, undermining their credibility in the process, and exacerbating the sell-off in train.
Consider this – equities now look cheap relative to bonds both in Australian and in the US. But if bond yields rise, the valuation buffer for equities gets eaten away, without necessarily commensurate earnings growth to offset, due to the COVID-19 shutdown phase. But the part of the equity market that will suffer the most is the expensive growth and bond proxy end, as this end of town has been the safe haven in turbulent times, and now has very large cap weights.
So a sell-off in bonds could make the equity market sell off worse. Indeed, such weakness would coincide with the thought that the Fed has lost control of bond yields. The alpha call is clear – we do not want to be in bond proxies, or related crowded exposures within the equity market. We would rather take on some cyclical risk. However, the beta call is less clear – more equity weakness coinciding with higher bond yields could ultimately drive up corporate funding costs, causing a tightening of financial conditions and undermining earnings.
For what it is worth, risk parity still has to shed another 5% to get back to equilibrium levels. And most of the work will have to be done by bonds, the biggest overweight, and now, the most overvalued asset class. So the absolute bottom on equities may not be in just yet – but we have to be thinking that alpha on the right reversal trades will trump beta downside on a one-year view.
Put differently, this is not a time to capitulate on risk – it is a time to get bearish on bonds.
Liquidate everything, eh.
I don’t think that central banks can or will do that.
Sure, it would cleanse the system of its distortions.
But via a depression.