Gross's Bond Supernova

[jennypenny]

I'm sure you've seen the tweet Bil Gross sent out today about the bond market exploding (imploding?). So here's my question ... what would that look like? How would that play out? I have a pretty good understanding of how stock and currency markets work and how trouble in those markets plays out for individuals. It's lowering to admit, but I don't really understand the intricacies of the bond market or how that bubble would pop beyond basic price movement. Is it obvious and I'm missing it? (quite possible)

sorry if this is a dumb question

[oldbeyond]

I'm no expert, but to me the scary thing about bonds, and especially the "safer" ones like high-rated government debt, is how riskless they are perceived to be. Thus even a small upset might trigger something truly gargantuan(gargantuan like the size of the bond market...). It's not just the debt itself, but the superstructure of insurance companies and pension funds. And then there's of course the effect on spending and sentiment on governments and consumers alike that higher rates on debt would bring.

I've been leaning away from bonds. I liked them for their ability to offset stock losses, but I think it's easy to forget how exceptional the last 35 years of collapsing interest rates have been.

[Dragline]

Well, Gross has been known for hyperbole in the past: http://www.businessinsider.com/bill-gro ... ket-2016-6

But he did not explain himself as far as I can tell.

[jacob]

It would look like the 2009 credit crisis but bigger and badder and encompassing the entirety of a very tightly wound global financial system. Pretty much anything that can be classified as a tradeable asset will be impacted.

The problem is that low interest rates have created some giant (dwarfing the housing bubble) carry trades in which financial institutions borrow (or are forced into it by things like QE where central banks buy back bonds and hand out short term cash) cheap short term debt from governments and then use that to finance longer term debt and various other riskier securities such as stocks and emerging market stocks.

This is a bit like picking up dollars bills in front of a steam roller.

The longer this goes on, the higher the valuations of long term debt and stocks and therefore the lower the yield. This makes the carry profit smaller and smaller and more and more risky. It has been going on for 30+ years by now.

The steamroller comes closer to the picking action. How many months or years is left? That's the big question.

Note that the short term end needs to be refinanced continuously. If central banks decide to raise the short end rate, this whole trade has to unwind. It will then become very clear that asset prices today have predominantly been bid up to super high valuations using borrowed money.

The situation is kinda like subprime housing except with subprime governments who also happen to set their own interest rates.

This is why the Feds continuously delay raising rates. Every time they talk about doing it, the USD suddenly becomes the cleanest dirty shirt in the hamper and rises. This causes US industries to become less competitive. It causes investors in carry trades where the short leg is US debt to unwind and sell whatever they invested in (Asia is a biggie) so it drops those markets as well. It dumps commodity prices (which are denominated in USD).

If any central bank moves too quickly, you'll start seeing margin calls. If that happens, people will start selling appreciated (non-underwater) assets to meet their margin calls. This will cause otherwise negatively correlated asset classes to become positively correlated, e.g. gold and bonds will drop along with stocks.

So the Feds will be moving real slowly, trying to push the consequences out over time.---Slower than they officially say they will.

[Dragline]

If any central bank moves too quickly, you'll start seeing margin calls. If that happens, people will start selling appreciated (non-underwater) assets to meet their margin calls. This will cause otherwise negatively correlated asset classes to become positively correlated, e.g. gold and bonds will drop along with stocks.

Strange times indeed. I have noticed that a lot of things seem a lot more correlated in the past year or so. Sounds like a good reason to hold a healthy pile of cash (or things that shoot out a steady stream of dollars).

I wonder if in the negative interest rate countries there will start to be such hoarding of paper money that it will start commanding a premium over electronic money.

[ether]

Also think about this:

now that interest rates are negative, the wealthy are literally saying I have no idea where to put my wealth. So instead of using it to invest in industry, consuming goods, or lending it out, they rather give it to the government and pay the government a small fee for the right for their wealth to be preserved.

Soon the government will the protector of wealth and taxes will go directly to repay bond holders. Like in Japan where 1/3 of all taxes goes to debt interest (they have never decreased the debt and it's at 250% GDP). If the debt crisis gets any worse people will be paying more taxes and getting less services, which is not a healthy combination for economic and political stability!

[BYC]

If any central bank moves too quickly, you'll start seeing margin calls. If that happens, people will start selling appreciated (non-underwater) assets to meet their margin calls. This will cause otherwise negatively correlated asset classes to become positively correlated, e.g. gold and bonds will drop along with stocks.

So the Feds will be moving real slowly, trying to push the consequences out over time.---Slower than they officially say they will.

So what is meant by 'losing confidence in the fed'? I see this phrase on zero hedge from time to time. I suppose it implies losing control of the steam roller and that the consequences, you mentioned, make themselves felt by the general (US) public.

Investors, globally, run for the exits, which I would assume would mean they convert to USD, as far as they can. The price of the USD increases over other currencies. Where do things go from their?

Does a strong USD not make it easier for the US to pay down its debts? (if the Fed even cares about that)

[Dragline]

Investors, globally, run for the exits, which I would assume would mean they convert to USD, as far as they can. The price of the USD increases over other currencies. Where do things go from their?

Does a strong USD not make it easier for the US to pay down its debts? (if the Fed even cares about that)

Yes, exactly. Because there are so many debts denominated/owed in US dollars and global oil must be purchased in US dollars (by some of the most peculiar and little known international agreements), the demand for them is overwhelming, My best guess is that the developed world competes to devalue their currencies, while the relatively undeveloped world continues to demand even more of the same currencies.

Americans truly do not know how lucky we are in this day and age.

[jacob]

@BYC - I haven't been reading zerohedge lately, but usually it just means that traders don't trust the official statements any longer.---not that things are about to go to hell in a handbasket. You can calculate how the market sees the probability of a hike directly from the price quotes. It's currently lower than what the Feds keep announcing. At some point it might not matter what kind of statements Yellen makes.

Deciphering Fed speak is an art in itself. For example, since some time ago, the keycipher has been "data driven", so instead of the words, people started looking at unemployment numbers. And they keep coming in low (I mentioned why elsewhere), so no hikes ...

[NPV]

It would look like the 2009 credit crisis but bigger and badder and encompassing the entirety of a very tightly wound global financial system. Pretty much anything that can be classified as a tradeable asset will be impacted.

The problem is that low interest rates have created some giant (dwarfing the housing bubble) carry trades in which financial institutions borrow (or are forced into it by things like QE where central banks buy back bonds and hand out short term cash) cheap short term debt from governments and then use that to finance longer term debt and various other riskier securities such as stocks and emerging market stocks.

This is a bit like picking up dollars bills in front of a steam roller.

The longer this goes on, the higher the valuations of long term debt and stocks and therefore the lower the yield. This makes the carry profit smaller and smaller and more and more risky. It has been going on for 30+ years by now.

The steamroller comes closer to the picking action. How many months or years is left? That's the big question.

Note that the short term end needs to be refinanced continuously. If central banks decide to raise the short end rate, this whole trade has to unwind. It will then become very clear that asset prices today have predominantly been bid up to super high valuations using borrowed money.

The situation is kinda like subprime housing except with subprime governments who also happen to set their own interest rates.

This is why the Feds continuously delay raising rates. Every time they talk about doing it, the USD suddenly becomes the cleanest dirty shirt in the hamper and rises. This causes US industries to become less competitive. It causes investors in carry trades where the short leg is US debt to unwind and sell whatever they invested in (Asia is a biggie) so it drops those markets as well. It dumps commodity prices (which are denominated in USD).

If any central bank moves too quickly, you'll start seeing margin calls. If that happens, people will start selling appreciated (non-underwater) assets to meet their margin calls. This will cause otherwise negatively correlated asset classes to become positively correlated, e.g. gold and bonds will drop along with stocks.

So the Feds will be moving real slowly, trying to push the consequences out over time.---Slower than they officially say they will.

Jacob, what is your investment thesis based on that? Cash (USD) is king, because that would be the key coveted asset in that scenario because the debt is denominated in USD and USD is legal tender to repay them and meet the margin calls? And then once USD prices of equities and other assets go on sale a-la 2009, go all in using that cash pile?

[NPV]

One concern I would have there is US government / Fed response. They are unlikely to just stand aside and watch the borrowers burn in that scenario - and they have the power to issue and inject (e.g., as some type of helicopter money / direct bail-outs of "TBTF" borrowers) as many USD as they wish - potentially leading to the opposite effect of runaway inflation. Thus the range of possible (and at least somewhat likely) outcomes for cash (USD) actually seems quite broad in this "bond supernova" both on the upside and the downside.

Perhaps this is why Soros is buying gold - while it is not legal tender and might indeed have the risk of being dumped to meet margin calls, it has other things going for it, such as restricted supply (relatively to fiat money which is potentially unlimited) and people traditionally rushing into gold at the sign of trouble, creating upside on the demand side.

[Dragline]

I wonder if in the negative interest rate countries there will start to be such hoarding of paper money that it will start commanding a premium over electronic money.

When I wish upon a star . . .

http://www.reuters.com/article/us-comme ... SKCN0YU1HW

[BYC]

So far banks have not passed on the neg. rates to consumers (in general. I know in Canada, a lot of fees have increased to compensate, for example). If they do, eventually people will take their funds out of the banks, because what is the point. So do govs/CBs ban cash? Seems unlikely,- that would just lead to another form of bank run.

No, I am guessing there will be yet another round of QE, or equivalent, when the 'time is right'.

[black_son_of_gray]

A bit of further explanation: https://www.janus.com/bill-gross-investment-outlook

[jacob]

So the Feds will be moving real slowly, trying to push the consequences out over time.---Slower than they officially say they will.

Slowly coming around to reality ... officialdom is.

http://www.bloomberg.com/news/articles/ ... -low-rates

[Duke Thunder]

I like Bill. He's the 'Bond King' after all.

His letters are entertaining, and I've read most of them in the past couple years. But I will say... he's been bearish to varying degrees for a while now. So I don't know if this is a real signal of a large and imminent market shift, or if recent events have inspired him to kick his usual rhetoric up a notch.

I think he's in a weird position, having made his money and fame in an asset class that looks like it could be a lame duck for the next decade or more. I guess only time will tell. In the meantime, I'm sticking with equities, real estate, and a bit of Ag/Au. I can't imagine people selling all financial assets and staying in cash for very long. I guess if we go down that deflationary spiral, my job and shitty 2% raise will be my winning asset!

[BYC]

Interest rates are approaching zero, or are negative in some cases, meaning there is no cost to risk. That does not seem tenable, which I think is his bigger point.

[jacob]

http://thealephblog.tumblr.com/post/146 ... pectations

[BlueNote]

If I was forced to make a call on this I'd say that the Fed won't make any dramatic increases in interest rates until inflation is really looking like a problem. Until then they'll probably rattle their sabres and occasionally float a test balloon by raising rates by a paltry .25% or some such.

They need more inflation in order to kill off some of the government/consumer debt and to provide a solid signal that the economy has reached full capacity. In fact pretty much all the developed countries are in the same place and they're all going to need (even more so in many cases) to follow a similar formula.

[jennypenny]

Did anyone listen to Kunstler's podcast with Kirk Bostrom? One thing they discussed was Richard Duncan's assertion that central banks could buy up paper indefinitely because the bonds eventually extinguish. Does that sound plausible?