It was February 4th, 1994, and I was on a plane to LA from Sydney. I was treating myself to 4-week holiday skiing in Aspen and then on to New York; 1993 had been a good year. Initially when my boss, Richard Farleigh, had resigned 10 months earlier I wasn’t sure what was going to happen. I was a proprietary trader in a team of 13 working for Richard at Bankers Trust in Sydney. He was the guru. I was 26 and obscure to management. What were they going to do?
To my excitement, Peter Warne made the decision to appoint me joint head of the desk (with Ian Cassie). I produced a record year for me at the time, about 9m AUD profit, and secured BT’s confidence.
So here I am, about to party. But I couldn’t afford not to trade for a month. So I kept my highest conviction trade – long Australian 10 year bonds, reduced it modestly so it could wear a little more volatility, and set a $1m trailing stop. I figured I had given the stop enough room that the trade should have no trouble surviving the month.
Disembarking after the 14 hour flight I am walking past a TV in the airport, and the banner at the bottom reads; “Fed hikes interest rates” What? It was 9am and the Fed was still meeting. And they have hiked rates?1 Indeed they had. And my $1m stop had already been hit, the position closed. It wasn’t the most pleasant way to start my celebratory holiday…
The initial market commentary was this was no big deal, it would be a modest cycle, and the rest of the world would be little affected. But the rest of the world had been in the mother of all carry trades. In particular, the favourite was long bonds in peripheral Europe. And everyone was fully loaded.
Bankers trust had 70 proprietary traders in New York and London. They had made a fortune for the bank in 1993 on peripheral bonds. By the end of 1994, they had “released” 68 of them. It was a bloodbath.
In Australia, BT traders as a group didn’t have a loss month. The traders turned and went with the move. It was a great opportunity. It took me until May to get profitable, but I finished with a solid result.
Are we about to repeat 1994?
Last month I implicitly gave a rerun of 1994 a 25% chance (a wages break-out in the US would be the catalyst in my mind, particularly combined with above consensus growth). On February 2nd, with the latest release of the US non-farm payrolls, the probability just went up.
This will silence the Fed doves. So what we now know is 3 hikes from the Fed this year is the minimum. We still think 4.
Could there be more? Certainly, but hard to say given we are still waiting to see who Trump will nominate for 3 new Fed governors this year. Which is very unfortunate. 2018 is shaping up as a year that is going to require very confident and brave leadership from the Fed. Will they be up to it? What if they are not?
What do I mean by brave? Brave means willing to apply the painful treatment. Short term pain for long term gain. Volcker did it in spades in 80 and 82. Greenspan in 94 and 2000. In these times these men had one goal. To tame inflation. And no one liked the medicine. But they gave it.
I think Yellen would have been brave had she stayed. She is a labour market economist, and she was with Greenspan as a hawk in the 90’s. But Powell? Ehhh. Who knows? He is a lawyer with 5 years’ experience as a governor. Will he be confident enough to make the tough decisions? Does it matter?
It does to bond markets. And so it will to equity markets. You see, bond risk premium hinges amongst other factors on the confidence that inflation will remain low and stable. Aggressive hiking cycles by the Fed in 94 and 99/00 created this confidence. Indeed, in these cycles, the Fed hiked when they forecast wages to rise. Given the delay in the impact of changes in monetary policy, they knew they had to be pre-emptive. But today, like the late 60’s, there is a high conviction that inflation and wages will never rise. The world has changed right? Technology, global supply chains, robots…
Except wages are now rising. And inflation expectations are now starting to rise.
Could it be that a near 30 year low in unemployment does create wage and price pressures? Could it be that the Fed has complacently drifted well out of the flags, and is about to find itself in serious trouble as the riptide of wages gains momentum…
At this stage they should be clearly more concerned. But not panicked. Hence my 25% probability perhaps has moved to 33%.
When should they/we panic?
Well this is where it gets interesting. One consultant was suggesting to me this week that if bond yields rise too much, the Fed will merely stop hiking and that will contain them. Rather naïve. You see, if bond investors are worried about rising inflation, a Fed that pauses will only increase that worry. After all, the economy needs to be slowed. A pause will allow growth to strengthen. Which leads me to the key. If growth was to strengthen this year at the same time that wages accelerate, that is terminal for bonds. Will growth strengthen? The latest Atlanta Fed forecast for GDP would alarm you.
Our forecast is a little more benign, but clearly strong.
Whether bonds yields have a major capitulation will depend on many factors. The Fed, reversal of leverage, and liquidity. The Fed may need to be aggressive to maintain confidence that its inflation objective will be met. (Haven’t we come a long way from 6 months ago!) That would likely mean more frequent hikes. Possibly even a 50 at some stage.
Volatility could trigger up to 3 trillion in bond sales
Then we have the leverage unwind. How will that progress? Usually it’s ugly. We have written about the leverage in risk parity funds and volatility targeting funds. Our estimate is an increase in volatility could trigger anywhere from 1.5 trillion to 3 trillion in bond sales.
Like the impact of portfolio insurance in 1987, the more that bonds weaken and volatility picks up, the more the funds will have to sell. And then there is liquidity. Not quite what it was. The increase in bank regulation in the US has meant banks no longer actively trade fixed income securities. Hence when a fund wants to sell, the banks find a buyer. They don’t warehouse. Markets move more…. In fact liquidity is now back to mid-90 levels.
All this sounds rather apocalyptic. To be clear it is not my central case. But it is a significant risk. If it happens, and your portfolio is not protected, you have no excuse.
It is a material risk you should have foreseen. Our central case still revolves around a modest pickup in wages and inflation. And a faster restoration of risk premium in bonds. This would still see us targeting 3.25-3.5% for the US 10 year this year.
So equities might suffer some setbacks, but not a disaster. This keeps the Fed, and indeed other central banks, very active. And the bond curve relatively stable, meaning 2 year bond yields and 10 year bond yields rise by a similar amount. For this scenario, we are heavily positioned short US rates around the 2-3 year sector. It has been very rewarding for the portfolio since September, and almost embarrassingly easy. We think it very much continues in 2018.
But we are also acutely alert to the risk of a complete capitulation in bonds. And very excited about how “cheaply” we can cover this scenario. Let me give you a few examples. If the bonds panic, the difference between the 2 year bond and 10 year bond will increase. The curve will steepen
We can buy an option on the shape of the curve. And because it has been relatively stable, we can buy it very cheaply. So we have a call on this spread moving above 60, as well as call spreads. On the former, if the spread went to 100 in the next 6 months, we return 28:1. If it moves above 65, we return 16:1 on our call spreads. Pretty nice risk rewards!
These trades are even cheaper in Japan. There we are positioned for the 10 year/20 year curve to steepen, given the Bank of Japan is determined to anchor 10 year yields near 0%. If this curve went to 80, we would make 80:1.5 Hello, that’s what we are after. 80:1 returns for a 25% chance. With global volatility still so low, there are just so many dare I say sensational ways to have these scenarios covered.
What about equities?
At the end of the day, it depends how far and how fast bonds sell-off. The chart below shows the instances where a bond sell-off generated a 5% correction in equities. The size as well as the pace of the sell-off matters. If I were to update the current sell-off, we have had a 36 point move in 49 days. Right into the danger zone…
For further insights from Ellerston Global Macro, please visit our website here.
Brett joined Ellerston Capital in November 2016 as Head of Global Macro. He has worked in the financial services industry for over 28 years with only one negative return/benchmark underperformance during this time.