Yes, you read that right. The risk asset market today is one very highly levered yield trade. Whether you look at FAANGs, Nasdaq, EM equities, High Yield, short volatility strategies or even long Treasury bonds, the juice that keeps asset price appreciation going is the low level of yields. Common sense tells us that as yields fell over the last decade, all asset prices went up due to both the discounting effect and the stimulus effect. The discounting game is likely played out. The converse is also true, i.e as yields go up, all asset prices should go down. We can certainly overthink this and say yes and come up with nuances, but the question right now is less about the nuances and more about getting the fundamental direction of the markets right.
Let us come back to why we think selling bonds may be a better hedge for managing equity risk today than selling equities outright. First, selling equities, which probably have a significant amount of embedded capital gains, is not tax efficient. Second, and as I have written before, both from a fundamental and technical perspective we have not seen the euphoric blow-off top rally in stocks which is the culmination of a bull market. This is a euphoric rally in equity markets that converts even the perma-bears into bulls, and not unlike the behavior observed in the Nikkei last week that brought out commentators calling for a doubling of that market. It is very hard to time equity market reversals, and since valuation effects take time to play out, fighting the market rally is dangerous even though valuation metrics such as the CAPE (Cyclically Adjusted Price to Earnings Ratio) is quite elevated in the US markets, at least. Third, the main reason to hold bonds, i.e. for capital preservation purposes, is so very “financial crisis-like”. Today, holding bonds is buying insurance against a non-event, while taking the risk of an actual soft default event, and by that I mean inflation, which perniciously steals purchasing power.
Financial analysts have been taught to trust diversification between stocks and bonds, and indeed the historical correlation on which much of this analysis is based has resulted in an incredible freebie over the last decade. Even though the correlation metric based on returns of stocks and bonds has been negative, on a cumulative basis both stocks and bonds have gone up. But the fundamental difference between stocks and bonds is that even though stocks can keep going higher without limit, bonds can only go up to a certain point. And when global yields are negative due to fiat from Central Banks, e.g. the European Central Bank and the Bank of Japan common sense tells us that it is close to the time to bail out.
Shorting bonds produces negative carry, and in a world of low interest rates and steep yield curves, this carry can be expensive, which is why some investors still own negatively yielding assets. But yield curves are drastically flat today relative to last year and certainly in the aftermath of the crisis. Therefore, the increasingly miniscule negative carry is no longer an excuse to maintain the status quo in bonds.
There are a couple of valid fundamental arguments for holding bonds over the long run, and indeed they should be held at the right price. The first is the possibility of Japanification of global economies, which simply means that an aging population wants safety and security, and will give up the potential for capital gains by investing in a security that guarantees some income and safety of principal. At current yield levels and with rising inflation, it is hard to argue that there is much real yield left in the bond markets. Maybe at 3.5% on the US treasury and 4.5% on the long bond there is some cushion. But that’s 100 basis points away. Second, relative to other bond markets, where yields are even lower, US yields look very high. But as investors well know, this “carry” by moving capital across countries comes with currency risk, and trade wars are all about increasing currency risk.
The Fed is in the process of taking away the punch bowl that presented markets with the sugar high which was much needed post the financial crisis. The Fed, however, is no longer the residual buyer of last resort. And the kindness of strangers, i.e. foreign investors from China and Japan, is fleeting at best in the current geopolitical climate of trade wars.
Also note that whether or not the current tax plan in front of Congress passes as proposed, it is a radical departure from the status quo and to fund it requires at least another $1.5 trillion of deficits. The only way the deficit will likely be financed is through more issuance, which means more borrowing. It is silly to imagine a magic bullet that creates a tax break without higher borrowing costs for the US government in the medium term.
Investing is always a matter of price. At today’s prices, bonds are neither insurance nor an investment. At best they are hedges, but not by owning them, but by selling them.
Vineer Bhansali, Ph.D. is the Founder and Chief Investment Officer of LongTail Alpha, LLC, a California-registered investment adviser and a CFTC-registered CTA and CPO. Any opinions or views expressed by Dr. Bhansali are solely those of Dr. Bhansali and do not necessarily reflect the opinions or views of LongTail Alpha, LLC or any of its affiliates (collectively, “LongTail Alpha”), or any other associated persons of LongTail Alpha. You should not treat any opinion expressed by Dr. Bhansali as investment advice or as a recommendation to make an investment in any particular investment strategy or investment product. Dr. Bhansali’s opinions and commentaries are based upon information he considers credible, but which may not constitute research by LongTail Alpha. Dr. Bhansali does not warrant the completeness or accuracy of the information upon which his opinions or commentaries are based.