First Bear Bond Market in a Generation: Liquidity Worries are Ramping Up

The bond markets are rattled and global yields are rising, signaling a possible reversal of an aging 33 year bull market in bonds that could have a major impact on all other global financial markets resulting in a reprice in asset classes across the board.

The price of bonds has been falling in dramatic fashion and the reason for this has varied. Some speculate the bond markets smells economic growth picking up in the second half of 2015, while others believe inflation expectations are picking up.

Bond market liquidity (or the lack thereof) has been identified by many market experts as the reason for these volatile moves. However, the most likely reason is that global interest rates are being re-priced to reflect reality.  This reality is that while global growth is not great, the end of the world never came and deflation is off the table.

The Liquidity Paradox

According to Matt King of Citibank, herd-like investing mentality has become the result of Central Bank monetary policies, including QE. Extreme easing has led all investors to seek out yields in riskier assets and adopt the same trading strategies. This has caused a mismatch of buyers and sellers when the market moves rapidly and everyone is exiting the same positions at the same time.

This condition has occurred for a variety of reasons. The main one have been caused by Dodd-Frank and a new regulatory environment, which requires banks to hold more bonds on their balance sheets, as well as the Volcker Rule that has banned banks from proprietary trading. According to Steve Schwartzman, CEO of Blackrock, one of the world’s largest private equity funds:

“The prohibition, when combined with enhanced capital and liquidity requirements, has led banks to avoid some market-making functions in certain key equity and debt markets. This has reduced liquidity in the trading markets, especially for debt.”

This has caused dealer inventories of corporate bonds to be reduced substantially. For example, Deutsche Bank’s inventories are down 90% since 2001, despite corporate bond offering doubling, says Schwartzman.

Banks were once the dealer of first resort, meaning they would stand buy ready to buy and sell debt securities from investors. All the new regulation has shrunk their risk appetite and put them into a position to, in effect, hoard cash.

Their job used to be one of flattening out volatility, when buying or selling stepped up in the market - that layer of the market architecture has now been removed resulting in fast rapid price swings and has been dubbed in past articles as “air pockets” in price.

Something Has Definitely Changed Globally

The chart below demonstrates how low bonds price, displaying the history of US long term rates (20+ years) since 1871. US long term rates are at historical lows:

Below are some global interest rate charts from a presentation I gave a few days ago.  Regardless of the reasons, the global interest rate picture has reversed what had been a big multi-year downtrend.

Market analyst, Martin Pring, puts together a World Bond Index (price) and it has broken down out of a multi year uptrend. As price goes down yields rise.  According to the chart below, there is much more downside in world bond prices.

The Japanese 10-year Yield has completed a bottoming pattern and is back above its downtrend line and 65 week Exponential Moving Average. Notice how swift and rapid the move is:

The same goes for the German 10 year Yield. It has broken through multi year resistance and is above its 65 week Exponential Moving Average. Martin Pring details at the bottom of the chart how incredible and swift this mega reversal is. Generally, moves like this are signs of the beginning of multi year trends.

The same type of extreme swing can be seen in the US 30 year bond beginning in 2015.

Looking at a daily chart of the UST 30-year yield confirms this chart and shows the start of an uptrend in yield. Notice again how big the move has been in such a short time.

The daily chart of  UST 10-year yield tells the same story.  In both cases Exponential Moving Average (EMA) crossovers are occurring and the charts are looking very bullish.

The short end of the yield curve UST 2-year treasuries has been very stable as would be expected, since the Fed is able to control the short end of the curve.

Corporate bond yields have also started to break their downtrends. This is important from a stock market and corporate/startup financing perspective and should be watched closely. This breakout is coming out of a multiyear downtrend.

Ominous signs

In financial circles, it is well known that the bond market changes trend ahead of all other markets. So this move in the bond markets is a signal of a change ahead for other asset classes. While this move can take time, this is something that should not be ignored based on the general trend reversals in the charts.

The bond market knows something.  Soon it enough it will reveal what that is. The markets can only postulate what that this. In the meantime, the entire term structure of the bond market is changing quickly.

What needs to be observed is how far these moves go and how quickly it happens. Orderly moves can be handled, it’s the disorderly ones that cause massive misallocations of capital whose aftershocks are felt in far reaching places, especially when liquidity dries up.