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PIMCO: What's Happening to Bonds and Why?


History will regard the ongoing phase of dislocations as a transitional period of adjustment triggered by changing expectations about policy, the economy, and asset preferences.

In historical episodes broadly similar to these, interest rate markets can overshoot and contaminate neighboring asset classes. These also tend to be periods where markets get quite myopic. Indeed, just witness the almost total absence of attention being paid by analysts to the improving net supply dynamics due to declining US Treasury issuance and the sharp fall in mortgage production.

The liquidity-challenged segments of fixed income are particularly impacted by the technical disruption in the "risk-free" Treasury anchor.
As an example, consider what has happened to emerging markets investments, be they in sovereign bonds, local bonds or foreign exchange. The across-the-board sell-off has been accentuated by the extent to which the crossover investor base ("tourist dollars") has overwhelmed the dedicated investor base. As a result, there are already some compelling opportunities at the front end of strong sovereign credit curves.

Technical dislocations are also evident in municipal bonds, where the impact of the rates sell-off has been accentuated by credit concerns derived from developments in Detroit and Puerto Rico. Here, the federally tax-free AAA segment of the market is trading at a yield ratio of 1.16x comparable maturity Treasury yields (Figure 5). This ratio was 1.0x at the end of April 2013 and a tighter 0.9x earlier in the year. The yield movement on AA federally tax-exempt municipals has been equally notable -- the ratio of yields has jumped from 1.07x for 30-year Treasury yields as of end-April 2013 to 1.24x currently.

What to do?

In reacting to the recent sell-off in fixed income, investors first need to be quite explicit about three (related) macro issues in particular:
  • The likely scale and scope of the US recovery, as a standalone and relative to what else is happening in the global economy;
  • The Fed's motivation for tapering; and
  • At what stage are nasty technicals likely to exhaust themselves, as lower bond prices discourage additional selling and also entice new buyers (be they liability managers, fundamental flows or fast money positioning).
As much as we wish for otherwise (particularly in view of the most positive high-frequency data), there is still not enough evidence to conclude that the US economy will be able to emerge decisively and durably from its low growth equilibrium in the next few quarters. The impact of sluggish domestic components of aggregate demand is compounded by declining growth in emerging economies, insufficient structural reforms and public infrastructure investments, and stubborn residual pockets of excessive leverage -- all of which limit the expansion propensity of corporate America, the one component of the private sector with the wallet (but not the will as yet) to spend.

Congressional political polarization is not helping the outlook for a high and durable fundamental US recovery. At a time when the economy needs a tailwind from Capitol Hill, lawmakers risk creating renewed headwinds when they finally turn their attention to steps to keep the government running and lift the debt ceiling. As for the Fed, we should all hope for "good" reasons for it to taper – meaning that the central bank has strong reasons to believe that the US economy is approaching "escape velocity." But the Fed could also taper for "bad" reasons – that is to say that its prolonged experimentation with unconventional monetary policy threatens to create too much collateral damage and unintended consequences (including concerns about misallocation of resources, excessive risk-taking and damage to the functioning of certain markets).
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