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The Monthly Banker: 22 April 2010
Are we on the brink of a secular bond bear market?
    
A Big Change Coming?
 
 
The day-to-day vagaries of the financial markets often leave participants bereft of the Big Picture. Ignoring such tectonic shifts, unfortunately, can wreak devastating impacts on investment portfolios. Remember the “day traders” who were bidding tech-stocks higher in the late nineties when the Nasdaq market had accelerated to the sky? Well, they disappeared when the dot-com stocks crashed. And the analysts who asserted that China could decouple from the States in 2008? They, too, vanished after the Chinese bubble imploded. And the starry-eyed optimists who were vouching for US$300 a barrel of oil two years ago? Gone, just like others before. A less well-known, but equally telling tale, is the uranium bubble that burst in 2007 (see Figure 1).
 
A central observation in all these financial episodes is this: A multi-year trend often accelerates parabolically towards the end – and then snaps suddenly. Predicting this peak, however, is impossible. No one knows when the trend will reverse. So for us the lesson is clear: When we see acceleration in important financial charts, we sit up and pay attention. Usually, the bigger the trend, the more deadly it will be when it reverses.  Very often, investors who become too focussed on the short-term rallies over the last few weeks will miss the Big Picture - and the opportunity to get out in time. 
 
Armed with this simple observation, we take a hard look at one of the longest running trends in financial markets: US bond yields.
 
After peaking at 15% in September 1981, the next 29 years saw the long-dated US government bond yield in a tenacious downtrend. Steep and volatile at first, the yield then ground lower in a way not anticipated by bondholders in the eighties - financial crisis-induced yield drops. For example, the 1987 crash, the 1994 bond market rout, the LTCM crisis, the Nasdaq collapse, 9/11, to the most recent one, the Lehman crisis, all precipitated the Fed chairmen to cut short-term rates, culminating in the so-called “Greenspan put” and “Bernanke put”.
 
But despite Bernanke’s best efforts to keep the rates low, long-term bond yields had rebounded strongly in 2009.  From the crisis low of 2.5 percent in December 2008, the 30-year yield is now trading at 4.67 percent – a full 200bps increase. Analysing the long-dated yield chart closely, the downward acceleration during late 2008 probably marked the “blow-off” stage of the trend – one that signals a major turning point is attained. Taking into account the steep rebound, I am more than 70 percent sure that the 29-year yield downtrend had bottomed out.
 
What are the implications of this?
 
One. Unless we see a repeat of the Lehman-style global crisis, long-term US bond yields are not likely to trade below 3% for quite some time. Chances of higher yields ahead are large – probably larger than most people realised. It is our contention that a secular bond bear market has begun!
 
Two. Against this backdrop, it is not advisable to hold large quantities of US bonds. (Rising yields equal to falling bond prices.) In the last secular bond bear market that lasted from 1946 to 1981, a 2.5 percent constant maturity bond purchased at 101 at the start would return the owner a pitiful 1­7 in 1981, a loss of 8­3 percent!  Some central banks, like China, are already disgorging the US bonds accumulated in the last decade. So watch for more such selling.
 
Three. As the Fed is determined to suppress interest rates near zero for a long time, banks are earning fat profits by borrowing cheaply (from the Fed, obviously) over the short-term and lending to the US government for the long-term. The difference between the two rates is now more than 3 percent. By leveraging up, banks can - and are - engaging in a new “carry trade”. Watch for a massive financial dislocation when the Fed raises the short-term rate in the distant future.
 
Four. Rising long-term interest rates mean that borrowing for the long-term will be more expensive. With the US budget deficit now ballooning out of control, these interest costs can add up. So, we expect the maturity profile of the US government debt to shorten from the current 5-year. But this contraction of the US debt maturity is a double-edged sword. Yes, interest costs are saved. But it leaves the US government to the mood of the bond markets when rolling over the ever-shortening debt – just look at Greece now! And, remember these words by James Grant, of the Interest Rate Observer: “The money supply can be counted, and so can the supply of debt. However, the potential supply of debt can only be imagined.” Therefore, a Lehman-style run on the US government bonds in the next decade is not to be ruled out.  
 
But, not every one agrees that a secular US bond bear cycle has begun. Sceptics, for example, point to Japan, where a 20-year deflation period still blankets the economy. No crisis on the horizon despite the debt-to-GDP ratio hitting 200 percent! Last we looked, the long-term bond yield there is still at puny 2.2 percent. So what’s the fuss in the States?
 
True. But keep in mind that interest rate cycles last for decades. Within this long-term trend, there will be cyclical moves. What we cannot predict now is whether long-term yields would move sideways from here, or, enter into a multi-year consolidation before moving higher. Markets are always full of surprises. The day of reckoning for Japan will arrive when everyone affirms this: “Surely it can’t happen here!” A whole generation of Japanese workers have already known nothing but low interest rates (and falling equities). A crisis usually explodes when it is least expected. For now, the Big Picture says that the US long-dated bond yields have bottomed out and the strategy calls for sell on strength.   
 
Monthly Banker
Jackson Wong
April 2010