Bond Market & Volatility

The Black Swan is an interesting book and a concept. It includes an example of a Turkey which due to complacency and routine feels it is normal to be fed everyday and that process will continue forever. Until one day it is fed upon. Stability and complacency breeds instability.

 Throughout history the fallacy of man has been to assume that things will remain normal even when the situations keep changing behind the scene. We are resistant to change. We don’t want someone to take our punchbowl. 

For 40 years, the bond market has been a stable factor in investors portfolio.

Fig 1 bond yields 1980 to current with USA Total Public Debt.

The 60-40 portfolio was a free trip to wealth accumulation. After the 1987 crash, the Fed removed risks from the market at every turn. The plunge protection team was created to prevent huge drawdowns. And if the market swooned it would step in to normalize. We had the great Asian currency crisis, the fall of LTCM, the tech bubble, the interest rate bubble the housing bubble and all of these bubbles burst but except some short term pain the fed was able to retain faith in the markets. Investors lost some but over a longer term period they have been better off. There has been no money making Machine better than the stock market and the reason for that was the removal of apparent risk in the market. Psychology has now accepted that the fed will step in to prevent market downturn at every fall and therefore complacency and stability builds instability. 

For these measures were made behind the scenes, the investors didn’t care as long as their returns were protected and risk taking was allowed to flourish at the cost of the economy. 

The financialization of the economy started in 1980s. Bonds were boring instruments made for pension funds and investors who were risk averse. But little was it known that they would become the most stable investments for next 40 years. In 1980s, while Japan had reached peak investment population and economic growth, USA and Europe were still growing, India and China weren’t even significant and there were ample of growth opportunities. The Central banks balance sheets were of very small sizes. Over the past 40 years the only thing constant has been the growth of debt the crushing of the interest rates and the rise of the central banks as the pillar stone of the economy.

Japans Debt relative to their GDP

USA Central Balance sheet size relative to their GDP

Japan Central Bank Balance sheet relative to their GDP

The reason central banks have gained so much power is because countries couldn’t grow organically and had to resort to debt as a means of growth. As the debt grew, there was a need to control interest rates. Occasionally these interest rates would rise far higher than what the economy could sustain and then the Fed would step in cut interest rates and stimulate the economy by buying bonds and growing its own balance sheet. Investors didn’t care because they were been fed and as long they were been fed they didn’t care. 

But alas all good things come to an end. In that context, the current times seem to be so. For every time the market has faced the dilemma of protecting the markets or protecting the economy and the currency, the Fed made a simple choice defend the markets. But as most central banks have now lost power to control their markets, the Fed chose to control it’s currency. For as long as the dollar is in power, the Fed can exert control and the Fed can exert control because other economies and their central banks are in a corner. The total balance sheet size of the European and Japanese central banks exceed their GDP. Imagine printing money just to keep buying bonds to prevent rates from rising and then losing control one day all because they didn’t realise they had reached their end of the tunnel with no light on the other side. Imagine them been ‘turkeyed’. The Fed could afford to do so as it’s balance sheet size is still smaller than the rest of the central banks.  the dollar basket is made up of yen euro yuan GBP and swiss francs. All of them have been easing more than the fed every time the markets went in to a fit. It also meant that these banks were trying to paper over the cracks their economies had and were not apparent or noticeable enough and as long as it worked the medicine was repeated. 

Central banks created the complacency and also the artificial stability. The Bond markets were the primary market where they functioned. Investors liked it because they could front run any central bank and make money. Large banks got easy money no one wanted to complain. But when the same bond bubble is bursting the central bank bubble has burst too. Today not many believe the lies central banks spew out every day for their capabilities have now been tested and their inability to foresee issues is also well understood. However those investors who have depended and held to every word of their Warlords are now in a pickle. The buy the dip mentality is struggling. Many have bought bonds in hopes the Fed will pivot but there seems to be no end to the inflation and interest rates rising. This is also the side effects of excessive easing which investors have so got used to. That they expected it to be same this time is understandable. That it didn’t happen is what has confused many and is now forcing them to seek answers. But those in power will not admit to their fallacy and will continue to focus on their path and data which is now in direct conflict with market philosophy. 

Conclusion:

The period of 1970 -80 may resemble current crisis as we had the dollar devaluation, the energy crisis the wars and ideological changes.  We are likely in a similar setting and will see high volatility in asset markets as focus shifts from financial to real economy. The only way central banks can bring their control back is to reduce the debt burden as it makes them less vulnerable to rate shocks and currency volatility. For that to happen inflation will have to rise as without a rapid fall in purchasing power it is not likely to happen. This means living standards will fall and revolts are likely. The investors had their Big daddy’s to look to but given that those poster boys have turned to savage villains there is expected to be little respite and very few places to hide. That we can remain in such situation for longer than usual is simply not in investors mind as a typical bear market is thought to be of 15 months and we are already in 12 month grind with no respite. Central banks have killed the turkey and now instability will reign.