· It is time to buy bonds.
· Risky assets no longer like it when Treasury yields rise. Yield rise is thus unsustainable.
· Many technical indicators also support a long duration position.
It is never good form for a strategist to miss a 170bp bear market in bonds. Mr. Macro misjudged the potential for the market to overshoot on the upside (yields). This is more than just the V-shape recovery camp winning out over the L or W crowd. Bond vigilantes are tapping into some darker fears. Here is a list:
Fed is no longer credible.
The dollar may not just decline, but crash
Foreign buyers are afraid, very afraid and may accelerate the process of diversification.
Faced with an economy deep in debt, courting inflation is tempting because it lowers the real cost of debt and can pump up asset values. Therefore, the fear is that the Fed may be slow to remove excess liquidity, delay rate hikes, and accommodate higher inflation. The lesson of the 1970s is once out of the bottle, it is hard to control.
Higher inflation means for the real exchange rate to stay stable the nominal exchange rate must fall. Inflation and the dollar are thus linked. A loss of Fed credibility, de-anchoring of inflation expectations, and a falling dollar are leading to a rise in risk premium – higher yields, steeper curve, and increasing volatility.
If convinced, then the recent price action probably makes sense. Mr. Macro understands the fear, but would like to inject a dose of reality into the equation. The Fed built credibility over a 25-year period. Mr. Macro thinks that it is unlikely that they can lose it in 3 months. Mr. Macro also believes that inflation expectations are not likely to become unanchored and the dollar is not going to crash.
Large market moves require a story or even a fear of something catastrophic to drive them. At this stage, the current price of bonds discounts a belief that is substantially disconnected from reality. As FDR said, “the only thing you have to fear is fear itself.”
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