Yes, It Will Crash. By How Much ?

The undercurrents have yet to hit retail space as institutional research reports emerge that are sounding faint alarm bells that buzz louder each day as summer approaches.

Many of these research reports are prohibited for public dissemination and I am unable to quote from them for I am a member of the public these days.

The growing consensus is that there will be a sell off in the bond market.

Let me summarise the case and readers can decide for themselves after.

1.      Globally, bonds have returned 3.7 percent this year through June 6, the biggest year-to-date gain since 2003, according to the Bank of America Merrill Lynch Global Broad Market Index. The index, which tracks almost 22,000 bonds with a face value of $43 trillion, fell 0.3 percent in 2013. (Source : Bloomberg)

2.  Despite the S&P 500 Index closing at all time high, credit spreads have stopped tightening and the spread between investment grade and junk bonds are starting to widen again. Investment grade spreads have not improved along with the equity markets indicating that we have hit a wall.

Personally, the first sign is when Spanish yields dipped under the US’s.

3. QE3 is now reduced to US 45 bio per month, with monthly reductions of US 10 bio, which leaves us about 4 months left after the FOMC on 19 June. BOJ is on course for a US 683 bio monetary base expansion this year.  ECB has indicated potential QE after last week’s meeting.
Additional stimulus, if any, is expected to come in Q4 from the BOJ and the ECB.

4. The US deficit is shrinking which means less bonds on the table in the form of US treasuries. In terms of supply, JP Morgan has forecasted that supply in 2014 faces a $ 460 bio shortfall. (Source : Bloomberg)
* Oddly, the year to date bond issuance has been roughly 10.5 trillion compared to total issuance of 16.23 trillion for 2013 which means we are ahead in terms of run rate.

5. Hedge funds have got it wrong so far this year and top bond traders around the world have returned less than the index, according to Hedge Fund Research Inc that is mentioned in Bloomberg.

6. Malaysia to India are opening their shores and capital markets to international investors. Africa is rushing to tug at investors’ wallets. Capital flows will be altering in the months ahead.

Now, what do we understand ?

1. Corporate prices comprise of credit spreads and interest rates. Credit spreads are at their lowest since the crisis began.

Graph 1. Markit Generic Invt Grade Index
MARKIT GENERIC 5Y IG CDS** still room to fall

Graph 2. Markit Generic 5Y HY Index
MARKIT GENERIC 5Y HY CDS** just a little more to go

2. World bond markets : USD denominated 33%, EUR 23.8%, JPY 14.9%, CNY 7.3% and the rest 21%.
Thus USD interest rates leads the way in the marketplace even as we are in a 30 year bull market.

Currently, the accepted explanation for capping US interest rates has been the ECB and their policy actions which has exerted considerable downward pressure on US yields, ignoring the stock market highs and positive economic data.

We have to acknowledge that it is different this time.

The FED has created a perpetuating cycle tying the fates of all together, institutions and individuals alike.

It is a case of all for one and one for all and markets are still feeding out of Yellen’s hands.

The markets will, and shall, engineer a bond market correction in the days ahead and sooner than later. I see the timing as after the BOJ (in case of surprises) this Friday and into the FOMC on the 19th of June (2am Singapore time).

There is no renewed impetus to buy anymore and most short positions have been cut. Bond funds are not going to see much more inflows from here and hedge funds who have held their shorts till now will not be cutting anymore. The big players will begin to tidy up portfolios into the summer lull, mid year closing and football World Cup.

Yet I cannot see a big correction with the prospect of further central bank easings and that is the million dollar question this time – how much and not whether a correction will happen or not ?

A yield driven correction is likely to drive 10Y US yields to 2.68 – 2.70% resistance level (current 2.6%) which could lead to a stock market correction of 2-3% and credit spreads to widen as a result.

Retail investors are the best customers of the bond world. They are expected to buy and hold and buy some more while the rest of the market can focus on trading. They are less price sensitive and have long term holding power.

Aso desu ka.

That is why they may not notice the correction this time.

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