Bond Crash!

The following is an extract from commentary that was posted at www.speculative-investor.com on 9th December. 

Who would want to own bonds at a time when the effects of one of history's greatest monetary inflations are about to start surfacing? Judging by the action in the bond market over the past month, no one.

Below is a chart showing the December T-Bond contract. The bond price spiked higher on Oct-31 and Nov-01 on the back of the US Treasury's announcement that the 30-year bond was going to become obsolete (a blatant attempt to manipulate long-term interest rates lower). In our Nov-04 commentary we stated that the bond market peak that had been created by the Treasury's manipulation would remain unchallenged for a very long time. In our Nov-21 commentary, following a break in the T-Bond's 6-month up-trend, we said to expect a rebound in the bond price to test the downside breakout prior to a resumption of the decline. So far so good on both counts, although as bearish as we have been on bonds we are still surprised at the speed of the decline.

Our on-going bearish view on bonds is based on our belief that the massive inflation that has occurred over the past 12 months (as at Nov-26 the year-over-year increase in the US money supply (M3) was an incredible 14.2%) is going to push prices higher over the next 1-2 years (excess money creation must result in higher prices somewhere in the economy). It made sense to us that the market would eventually have to move long-term interest rates much higher (move bond prices lower) to account for the natural effects of this monetary inflation. However, although the discounting of inflationary effects is most likely the primary driving force behind the recent collapse in bond prices, the spectacular rate of descent suggests that other factors are also at work. Some factors that may have contributed to the crash are discussed below.

Firstly, it is well known that some market participants received a 'heads up' regarding the Treasury's decision to stop selling 30-year bonds. It is generally thought that this 'heads up', or forewarning, occurred several minutes prior to the official announcement. However, based on the price action of stocks and bonds between mid-September and late-October we suspect that some players knew of the Treasury's plans as much as 6 weeks prior to the official announcement. This would certainly explain the ability of bonds to rally in tandem with stocks during the 6-week period following the Sep-21 stock market bottom. (Historically, stocks and bonds rallying together is quite normal. However, during the credit bubble conditions of the past 4 years such behaviour can definitely be considered as anomalous.) It would also help explain the incredible speed of the bond's descent during the 5-week period following the official announcement. When a market is pushed well away from its natural trend, the snap-back to that natural trend tends to be ferocious.

Secondly, the market is perhaps coming to realise that the Fed has not only taken short-term interest rates too low, but is likely to take them even lower for reasons that have nothing to do with the economy. This is also what happened during the early-1990s, a period during which the Fed kept cutting short-term interest rates for 18 months after the economy had bottomed in a (successful, as it turned out) attempt to repair the balance sheets of the major banks. The difference between then (the early-1990s) and now is that the inflation rate (the money supply growth rate) was then extremely low whereas it is now extremely high. In the early-1990s there was no reason for the bond market to fight the Fed. There are a trillion reasons for it to do so now. Today's bank-related problems (for example, JP Morgan Chase, Citibank and Bank of NY have recently admitted to having a combined exposure of $7.5B to the bankrupt energy trader Enron) could force the Fed to take short-term rates lower than would be justified by economic considerations alone, thus exacerbating the existing inflation problem. 

Thirdly, many large operators in the debt market use a process called "delta hedging" to protect themselves against losses. In simple terms, delta hedging involves buying in a rising market (to mitigate the risk of losses in a short position) and selling in a falling market (to mitigate the risk of losses in a long position). Delta hedging works very well in theory when certain assumptions are made, but in practice it can exaggerate price moves and lead to even greater losses (especially when a lot of large traders are lined-up on one side of a trade). As bonds moved higher into early-November and then lower into early-December, delta hedging would have certainly added to the volatility.

In summary, our belief is that a growing recognition of the inflation problem was the catalyst for the T-Bond's substantial decline, while the three above-described factors probably contributed to the rapid speed of the decline. 

As an aside, claims that the recent dramatic rise in long-term interest rates is the result of the market discounting next year's economic recovery are false. We actually think that the consensus view on the economy - that an economic recovery will occur during the second half of 2002 - is unduly pessimistic. Our view is that the economy will be showing definite signs of recovery by the first quarter of next year. However, if the debt markets were discounting an economic recovery, as opposed to discounting inflation or some other problem, then the yield spread would be contracting (short-term interest rates would be rising relative to long-term interest rates). This is not the case. The yield spread continues to widen and hit a new multi-year high last Friday (7th Dec).

At some point during the next 3 months bonds are going to reach a low from which a substantial rally will begin, a rally that will probably retrace 50-60% of the preceding decline. However, it is our view that any rallies in bonds over the next few years will be of the bear market variety. We don't yet have enough technical evidence to pronounce the 20-year bond bull market dead, but the bull appears to have a terminal disease.

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