Another Sign of Trouble in Bond Markets

Fountain pen and glasses on stock chart.
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In Port Phillip Insider, we’re always on the lookout for trouble.

In fact, that’s the main reason many folks see us as ‘doom and gloomers’.

But, in our view, we have every right and every justification for looking out for trouble. And besides, there’s a lot of it around at the moment.

One of the themes we’ve followed is interest rates; specifically, their rise and fall.

But looking at bond yields isn’t the only thing to watch. A report from Bloomberg offers another warning sign:

The world’s biggest bond dealers are getting saddled with Treasuries they can’t seem to easily get rid of, adding to evidence of cracks in the $13.3 trillion market for U.S. government debt.

The 22 primary dealers held more Treasuries last month than any time in the last two year, Federal Reserve Bank of New York data show. While at first glance that may suggest a bullish stance, the surge in holdings is more likely the result of investors including central banks dumping the debt on the firms, said JPMorgan Chase & Co. strategist Jay Barry. Foreign official accounts sold a net $105 billion of the securities in December and January, an unprecedented liquidation, Treasury Department data show.

What’s the relevance of this?

It perhaps partly explains the increase in bond yields from mid-February through to mid-March. The chart below is of the US two-year government bond:


Source: Bloomberg

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The yield increased from 0.6% in February, to nearly 1% just over a week ago. That’s a big move in the bond market…as was the move down from December through to mid-February.

If JPMorgan Chase & Co is right about the build-up of inventory at the primary dealers, it could suggest that interest rates will have to go higher in order to clear the inventory.

Remember, interest rates are just like other pricing mechanisms. All else being equal, if a shop wants to clear excess stock from the shelves it has to lower prices.

If a bank wants to increase the number of loans it writes, it has to cut interest rates. And, if a Treasury department wants to offload all its bonds, it will have to pay investors a higher return.

To do so means increasing interest rates, which means higher costs for the US government — and its steadily growing US$16 trillion debt.

Tough to predict

Call it what you like, but it all leads to the same thing: a currency war.

Movements in interest rates have a direct bearing on the value of a nation’s currency. That’s not to say the currency will always move as expected, but there is an indisputable relationship between interest rates and currencies.

That’s why last week’s statement from the US Federal Reserve, and the publication of the ‘Dots’ chart, caused the Aussie dollar to soar by two cents against the US dollar.

If you’re wondering what the ‘Dots’ chart is, we’ll show you here:


Source: Bloomberg

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This chart may look complex at first, but it’s simple.

The yellow dots are the predictions for the Fed Funds Target Rate of Federal Open Market Committee (FOMC) members. The green line pinpoints the median rate for those predictions.

Interestingly, the red line indicates where the market believes the Fed Funds rate will be for the corresponding period. As you can see, the median rate, according to the Fed, is for the Fed Funds rate to be at 3% by 2018.

But the market doesn’t believe it. Based on the prices for interest rate swaps, investors figure the rate will be somewhere around 1–1.25%.

That’s a big difference.

It’s another example of central bankers being out of touch with reality. The FOMC members are either grossly over-optimistic about the strength of the US economy, or they’re trying to use psychological mind-power to push the market that way.

If history is anything to go by, it’s not likely to work. Looking back to 2013, FOMC members have almost completely overestimated the path of interest rates, as the chart below proves:


Source: Bloomberg

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Going back to 2014 — when talk of rising interest rates more or less began — FOMC members have set rate targets well above where the rate ultimately was.

And, all along, the market told them so, by pricing interest rate swaps below the FOMCs estimates.

The expression is ‘jawboning’. It’s the practice of central banks and Treasury officials talking about raising (or cutting) interest rates, hoping they don’t actually have to raise or cut them.

That’s what the Fed did through the second half of 2014 and almost the whole of 2015, before they realised they had to do something — they raised interest rates a quarter of a percentage point…and now realise the US economy probably couldn’t cope with another increase.

Hence the need for more ‘jawboning’ by the Fed.

But it’s not just the US central bank trying to use the threat of an interest rate move instead of actually moving rates. The Reserve Bank of Australia (RBA) is in on the act too.

While the RBA may not be a major player in the global currency wars, it is a player. As the Sydney Morning Herald notes today:

Analysts believe the Aussie dollar’s recent strength may be sitting uncomfortably with the RBA, though they are divided over whether the bank will decide to act on it.

Ewa Turek, investment analysts for Morgan Stanley’s Wealth Management said the catalyst for an AUD correction is in the hands of the US Fed, though this may take some time.

“As the currency approaches US77c the RBA is under increasing pressure to join the currency war,” Ms Turek said.

“The biggest risk to our US62c call is further unconventional monetary policy,” she added.

Of course, talk of currency wars and trying to play it for the advantage of investors isn’t a new topic for Currency Wars Trader subscribers.

The twin goals of this service are to:

  1. Make money from the IMPACT of the currency wars
  2. Protect wealth against the impact of the currency wars

You can find out more about the strategy here.

In truth, trading the market, based on either broader currency wars or even ‘battles’ within them, isn’t easy.

You can get the story right, the trade idea right, and even the timing right…but then the market can react in a way you least expect.

Take the euro. After falling from US$1.40 in 2015 to close to parity with the US in early 2015 — and despite every message that European Central Bank president, Mario Draghi, can give about cutting rates and printing money — the euro is up 3% over the US dollar in the past year.


Source: Bloomberg

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That’s all part of the currency wars. It affects the markets in ways that aren’t always possible to predict with 100% accuracy.

But that’s not an excuse to ignore it.

The folks at Currency Wars Trader are doing their part to help investors make at least some sense of what’s going on in the markets.

That involves looking for short and long term trading strategies, to potentially profit from the big moves in the currency wars.

Interestingly, as I’ve learned, trading the currency wars doesn’t necessarily mean trading the movements of the foreign exchange markets.

It can involve commodity prices, ETFs, indices, and even individual companies.

It’s a fascinating way to play this super volatile market. If you’ve got any interest in trying to figure out what’s going on and what to do about it, check out Currency Wars Trader here.

Cheers,

Kris

Ed note: The above article was originally published in Port Phillip Insider.

Kris Sayce
Kris Sayce, dubbed the ‘Jeremy Clarkson of Australian finance’, began as a London finance broker specialising in small-cap stock analysis on London’s Alternative Investment Market (AIM). Kris then spent several years at one of Australia's leading wealth management firms. A fully accredited advisor in shares, options, warrants and foreign-exchange investments, Kris was instrumental in helping to establish the Australian version of the Daily Reckoning e-newsletter in 2005. He is currently the Publisher, Investment Director and Editor in Chief of Australia's most outspoken financial news service — Money Morning.
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