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Bond Owners Will Get the Last Laugh

Stocks have been all the rage during the past few years, as every stock seemed to magically rise without any regard to valuations, earnings or profits. Meanwhile, bond owners, who have taken the more cautious approach, have been left behind, even as the current economic cycle fast- approaches its tenth year. While stock investors are eagerly looking for the market to reach new highs and continue for decades to come, it is bond owners who are holding the biggest opportunity in the stock market today.

With the Federal Reserve in their third year of monetary tightening, which is one of their longest tightening cycles on record, the broad stock market has started rolling over and is setting up for a large move lower. While few stock investors believe stock prices are headed lower, because investor memory is rather short, the Fed has created and ended every expansion because they continue attempting to manage the economic cycles.

During the next major move down, when I believe stock prices will revisit their 2016 lows, bond owners will be faced with a tremendous opportunity, whereas stock owners will be trapped hoping for stocks to rebound. The reason stock owners will be trapped, potentially forcing them to sell into a falling market, is due to the current lack of liquidity in the markets.

Few investors understand liquidity, let alone how the bond market works or how bonds affect liquidity. Liquidity is expressed as the amount of cash in the financial system that could be used to purchase stocks and the ease at which existing investments can be converted to cash.

During periods of high liquidity, accompanied by rising stock prices, which creates liquidity, investors who wish to sell stocks can do so quickly, easily and at market prices. During periods of low liquidity, accompanied with falling stock prices, investors wishing to sell quickly find out the asking price for their shares is well below the market price. Those who are forced to sell during periods of low liquidity cause stock prices to rapidly fall, which further drains liquidity.

It is the lack of liquidity, caused by the Fed tightening monetary policy and investors overcrowded into stocks, which leads to large declines in stock prices during Bear markets, like what investors experienced during the dot-com and mortgage bubbles. Aside from cash, the most liquid investment available in the market is U.S. Treasury bonds.

The market for U.S. Treasury bonds is the widest and deepest of them all. At any given time an investor can easily sell their Treasury bonds because there are always buyers for Treasure bonds. It’s interesting that U.S. Treasury bonds can create and remove liquidity from the markets, which can help stock prices rise, but could also cause them to fall.

Most investors would argue that higher interest rates would lead to a liquidity drain, because high interest rates would cause investors to sell stocks to buy bonds. Yet, when charting Treasury yields against the broad stock market, the opposite is true. As interest rates fall, so do stock prices. This relationship doesn’t occur from investors wanting lower yields, it happens due to how rising and falling Treasury yields create and remove liquidity from the financial system.

It is important to understand, unlike most stock markets in the world, our market has many ways for investors to speculate against it. This is part of the reason why the U.S. stock market tends to rise higher than foreign markets during Bull markets, and why it tends to outright crash during Bear markets. Leveraging U.S. Treasury bonds is one way investors and speculators create additional liquidity.

The traditional way bonds create liquidity is when investors sell bonds to buy stocks. The act of selling a bond creates liquidity, because the cash proceeds from the sale of a bond can be used to buy stocks. This relationship is particularly true in aging Bull markets when investors are finally convinced stock prices will rise forever and they rush to sell their bonds to buy more stocks. It is the speculative nature of the Treasury bond-market that can rapidly create and remove liquidity from the stock market.

Like stocks, investors can ‘short’, or sell Treasury bonds they don’t own. By selling bonds they don’t own, investors can create additional liquidity to buy more stocks. Short-selling Treasury bonds was one of the most popular trades in 2018, as investors convinced themselves interest rates were going to 5-7%, even though long-term interest rates fall during the Fed’s monetary tightening cycles.

An investor looking to short the Treasury market borrows a Treasury bond from a securities dealer and immediately sells it. When the borrowed bond is sold, the investor receives cash from the sale. The cash is then used to buy risk assets, commonly stocks. The act of shorting a Treasury bond creates additional liquidity to buy stocks, but the investor who shorted the Treasury bond still has a debt to the securities dealer.

The short-seller is now in debt to the securities dealer for a Treasury bond. Until the debt is repaid there is a cost to the short-seller, which is the monthly dividend payment to the owner of the bond, or the securities dealer, that must be paid by the short-seller. As long as Treasury yields are rising, which causes Treasury bond prices to fall, the short-seller can turn a profit—as long as yields rise enough to offset their monthly-interest cost to the securities dealer.

When a large number of short-sellers speculate against the Treasury bond market, they can drive interest rates higher due to the sheer number of bonds being sold, while causing the stock market to rise by redeploying their cash proceeds to buy stocks. Starting in 2017, short-sellers amassed the largest speculative short position in U.S. Treasury bond market history, in the midst of a Fed tightening cycle.

Unfortunately, the Treasury short-sellers are going to soon find themselves on the wrong side of the trade, which will create a huge opportunity for Treasury bond owners. Most investors and professionals believe the Fed’s monetary tightening, in conjunction with record Treasury issuance due to the record government deficits, will lead to higher long-term yields. While these speculators have been on the right side of the trade during most of last year, they don’t understand how tighter monetary policy leads to lower long-term bond yields.

At some point, these short-sellers will need to repay their debt to the securities dealers in the form of a U.S. Treasury bond. Short-sellers exit a trade when they have realized their target profit or when they are squeezed out. A short-squeeze occurs when a short-seller’s profit margin rapidly narrows or when they start taking a loss and are forced into exiting their short position. For a Treasury short-seller to exit their short position, they need to purchase a U.S. Treasury bond to give back to the securities dealer.

The forced act of short-sellers buying U.S. Treasury bonds causes bond prices to rise and interest rates to fall. Just as short-selling created liquidity, it removes it when the short-sellers are forced to sell stocks to buy bonds. Short-sellers could use their existing cash to buy back their borrowed Treasury bonds, but with cash levels near historic lows, it is unlikely there is enough cash available for short-sellers to cover their Treasury shorts.

Without sufficient cash on hand, short-sellers will be forced into selling their stocks, or other risk assets, to prevent further losses from falling Treasury yields. As short-sellers are forced to sell stocks into an illiquid market, stock prices will rapidly fall, which will create an opportunity for those holding Treasury bonds to sell to the short-sellers, and in turn, buy stocks at a lower price.

Speculators haven’t just been shorting U.S. Treasury bonds. They have been shorting everything except stocks and crude oil, which is why most asset classes have underperformed stocks and crude oil, prior to October 2018. While many investors believe the Fed has turned dovish, the Fed is continuing to drain liquidity by unwinding their balance sheet by $50 billion per month. By draining liquidity, the Fed is putting downward pressure on asset prices and Treasury yields, which will force speculators to exit their large short-positions.

When these large speculative short-positions are flushed out, those with highly liquid investments, such as U.S. Treasury bonds, will have an opportunity to buy stocks at a much lower price than current prices. For this opportunity to play out, it will require the Fed to back off tightening monetary policy, even if temporarily.

A similar occurrence happened in 1929 during the onset of the Great Depression. Stock prices fell approximately 50% from their peak before the Fed backed off, which spurred a 50% rally in stocks over the following six months. Once it became clear the economy was not recovering, stock prices resumed their peak-to-trough decline of 80%.

Even though investors believe the Fed is backing down, they haven’t. I believe the Fed will back off once stock prices fall enough, because consumer discretionary spending has been tied to stock prices for the past decade. This coming short-squeeze and ensuing rally will likely create an unprecedented opportunity for bond owners, who will finally get the big payday and the last laugh.

Is the Stock Market Headed Higher or Lower? (02/06/19 – 15 min)

https://www.facebook.com/svmfin/videos/338405427003117/

Weekly Economic Update (02/08/19 – 36 min)

https://www.facebook.com/svmfin/videos/363319094266954/