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Peter Atwater: Volatility Is Coming to a Bond Market Near You


Bond market investors may be pushing their luck a bit too far in the new era of total return fixed income investing.

I must be getting old.

I can still remember when investors bought bonds for income.

With the 30-year Treasury hovering near a record low at 2.23% and the sovereign debt of many other developed nations actually negative, it is hard to imagine how any investor is buying sovereign debt for yield today.

To believe that they will somehow achieve a real rate of return on their money, yield buyers must see deflation well out beyond the horizon. Even with the recent surge in deflationary talk, I suspect there are only a handful of die-hard deflationists taking matters into their own hand by buying bonds.

This begs the question, if investors aren't buying bonds for yield, why are they buying bonds today?
As best as I can tell, there are four principle reasons:

First, after almost thirty years of a bull market, income-searching bond investors morphed into total return bond buyers.  Yield, once ample, is now a small part of investors' profits. The big money is in getting the direction of interest rates right.

For retail investors and day traders this has spurred the growth in Treasury-backed exchange ETFs. Why buy Treasuries outright when you can buy ETFs like TLT or even better "ultra" ETFs like UBT instead? When you are leveraged and far out the curve, big moves in interest rates mean big money. And if you are an institutional money manager, why not use Treasury futures? Thanks to the leverage, the returns can be even greater.

Who needs yield to make money in bonds? Interest rate volatility and the right directional call are how you make the real money, especially if you play far out on the curve. With absolute yields low, small swings mean big money.

Over the past year, TLT is up more than 30% as the long end of the curve unexpectedly fell. Contrarians were richly rewarded.

The second reason investors are buying bonds is to front run central banks.  Earlier this week, I read this in the Wall Street Journal:
"We have bought [negative-yielding bonds]," said Graeme Caughey, head of pan-European macro at Aberdeen Asset Management. The reasoning: Other investors may be willing to buy at an even higher price. "There is still scope for capital gains, which could happen if central banks reduce policy rates further, but also in simple market dynamics, if there are more buyers than sellers. The ECB will be buying a very large quantity of these things, so there will be very limited net supply," Mr. Caughey said, referring to bonds in the euro area."
The ECB, like the Fed before it, has made no secret of its interest in buying sovereign debt through QE. Buy what you think a central bank will want for its portfolio and you can be handsomely rewarded if you're early enough.

Again, though, the value in owning bonds doesn't come in the coupon, it comes in price appreciation.

The third reason investors are buying sovereign bonds is to protect themselves against foreign currency depreciation. With cash yielding less than nothing now, investors have to go out on the yield curve when they play the foreign exchange game. And in countries like Switzerland, where the 1-year yield is now below negative 1% and the curve is negative out ten years, investors have to throw a Hail Mary pass. Protecting yourself in Swiss francs today means buying your francs at a price 30% higher than they were a few weeks ago and then purchasing 10-year Swiss government bonds, assuming you can even find them.

In a haven like Switzerland, bond buying is the TINA trade at gun point. The value in owning bonds doesn't come in the coupon, and probably not even in the total return. It comes from sleeping well at night -- albeit in a very expensive Zurich bed that you just made for yourself.

The final reason investors are buying bonds is because the investor is a central bank or sovereign wealth fund.  For these investors, the value in owning bonds has never been the coupon. Bond purchases are a means to monetary or fiscal policy objectives.  Price and coupon are irrelevant.

Put simply, the developed sovereign debt market, once a place where investors bought yield, is now a casino where price sensitive buyers bet on the actions of non-price sensitive buyers. The action of the group for whom price is everything is entirely dependent on the actions of those for whom price is meaningless.

I highlight this and the four factors above this week because the investment community has lost complete sight as to how falling confidence in central banks will impact the fixed income world. All of the attention so far has been on foreign exchange volatility.
I believe the market is missing the biggest risk now out there.

Recently, the Swiss Central Bank acted not like an old-fashioned central bank, but like a modern day portfolio manager living in a world of mark-to-market accounting. Having made a bad call on the euro and then doubling down on its bet, the central bank decided to cut its losses last week. It capitulated. It swapped the short-term interests of the nation's exporters for the country's long-term reputation as a strong currency.

Implicit in the Swiss Central Bank's action was a decision to stop buying additional euro-denominated sovereign debt. As a future buyer, the SCB is now out.  But that is the best case. It presumes euro-denominated interest rates stay low. If rates begin to rise, it is hard to see how the SCB can just sit there. Having already taken a huge hit on its portfolio due to foreign exchange losses, the central bank is unlikely to tolerate a second hit resulting from higher interest rates.

But please appreciate how little rates have to move up for the Swiss Central Bank to lose a lot. Judging by the timing of its enormous balance sheet expansion (dare I suggest explosion?), the central bank bought euro-denominated sovereign debt at THE very peak in price. A small reversal in the absolute level of interest rates could bring a sizable loss.  If investors begin to see central bank losses as threatening Switzerland's safe haven currency status, the pressure for the SCB to sell will rise.

And I doubt the Swiss Central Bank will be alone in its action. Once one central bank behaves like a portfolio manager others, will have to follow.

The easy money in betting on central bank balance sheet ballooning is over. The Swiss Central Bank's "surprising" actions last week show that there are limits. Central banks are not as predictable as investors thought.

Right now, investors are coming to terms with that in the foreign exchange market, especially with the follow-on "surprise" actions by other central banks. But this volatility is about to move into the bond market.

Three weeks ago, global bond investors heard that the ECB will by $1.2 trillion of European sovereign debt under an unlimited QE program. The ECB will do whatever it takes to keep interest rates low to jumpstart the European economy.

Not to be flippant, but investors just bought the peg. They believe that the ECB can and will keep interest rates low, just like they believed that the Swiss Central Bank could and would keep the Swiss franc/euro exchange capped.

I wouldn't count on it. Weak social mood in Europe puts promises from the ECB at great risk.

The willingness and ability of the central bank to act is entirely dependent on the confidence of the region's leaders.

With the euro at a 12-year low and European sovereign debt yields breaking records, I would be extremely careful here. As I offered above, the bond market has become a casino where price sensitive buyers bet on the actions of non-price sensitive buyers. If price sensitive buyers aren't confident in which way to bet, there won't be a bond market.

Peter Atwater's groundbreaking book "Moods and Markets" is now available on Amazon and Barnes & Noble.
"Peter Atwater brilliantly provides a framework for understanding both the socioeconomic hubris that led to the great credit bubble of the past decade and the dark social-psychological hangover that has resulted from its collapse. In so doing, he offers an invaluable guide to what promises to be a very difficult and turbulent period ahead as we experience what he calls the 'me, here, and now' behavioral tendencies of the post-crash world."  -Sherle R. Schwenninger, Director, Economic Growth Program, New America Foundation

Twitter: @Peter_Atwater
Position in SH, DBC, USO and TBT; Creditor of JPMorgan
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