Bond Guys

“The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.”  – Rudi Dornbusch

From my very first job out of college working at Lehman Brothers, I’ve always been an equities guy. I remember touring the trading floors there during my final round interviews and noticing the stark difference between the environment on the equities trading floor vs. the fixed-income trading floor.  The equities floor was loud, lively and intimidating. There were frisbees and nerf footballs whizzing around the floor, and lots of screaming and yelling constantly. It felt like a locker room which to any outsider, is both exciting and frightening at the same time.

The bond trading floors were much different. They were nearly silent. Lehman was known to be a market leader in bond trading and on the floor rows of traders would just sit there all day doing their bond math while producing PnL that the equity guys could only dream of matching.

Bond guys are without a doubt smarter than equities guys. I’m sorry if you think otherwise, but you are just plain wrong. Stocks get most of the mainstream attention but if you want to really look at what drives Wall Street then you have to ask the bond guys. The US rates market is the largest and most liquid market in the world and naturally the best and brightest talent accrue there. This is why I have a lot of respect for bond traders and also why I tend to take little signals like a partial yield curve inversion pretty seriously.

I’ve been getting a lot of questions this past week about bonds and the yield curve flattening chatter that has been making the rounds, which we spoke about last week. In case you haven’t been paying attention, two weeks ago Fed Chairman Jay Powell “blinked” which in layman’s terms simply means that he changed his monetary policy narrative by saying that interest rates are “just below” neutral (their target), hinting at a more dovish stance on rate hikes next year.  This caused the 2s5s portion of the yield curve to “invert” which led to a whole new barrage of market commentary talking about how the inverted yield curve is a telltale sign of an impending recession.  A yield curve inversion refers to a situation where short-term rates exceed long-term rates.

Now just because the 2s5s (and 3s5s) inverted, that doesn’t constitute a full yield curve inversion, nor does it mean a recession is right around the corner. There is typically a long lag between an inversion and a doomsday scenario in the markets, but the key point here is a portion of the curve flattened which is a sign of economic weakness.

So what actually drives these moves in the yield curve? Well, the answer is, “it depends”.  The bond market and yield curve are both highly complex and there are a number of factors which contribute to bond pricing at any given time.  On a very general and broad-based level, the yield curve is almost entirely driven off of investors’ expectations. What do I mean by this? Let me break it down for you.

The short end of the curve is driven by market participants’ view of near-term central bank policy. Will the Fed continue to raise rates (including this December), or will they pause? Is the economy strong enough to handle a rate hike (since they are supposed to be normalizing policy now after 9 years of free money), or will that cause too much collateral damage in the markets for them to move forward (yes, sadly not all Fed action is strictly data dependent, they do have the burden of the global markets now)?

The long end of the curve is driven much more by macro elements such as where we are in the business cycle, budget deficits or surpluses currently and savings rates. In addition to these, there are other factors that also affect the yield curve such as inflation expectations, risk and market volatility, and even bond specific variables such as convexity and call provisions.

As you can see there is no easy and simple explanation of what drives the yield curve. That’s why the bond guys are smarter than the equities guys. They need to crunch their fancy bond math to figure out how much they should be compensated above and beyond inflation for holding various degrees of government debt over the next few years.

Now back to the inversion. Remember, it’s all about investors’ expectations. If the market believes the Fed is taking a more dovish stance (1-2 hikes left) then they’ll end up selling the short end of the curve causing a situation where short duration now pays the same (if not more) than mid duration bonds (5 years+). The problem with this situation is that by not hiking as aggressively, this, in turn, could alarm financial markets that policymakers are actually more worried about the economy than they’ve let on to be (which might mean an impending recession).

And if the market believes this to be a temporary situation, in which after say three months the Fed decides to keep tightening liquidity, then rates for maturities longer than three months will decrease less than rates shorter than three months since the longer the maturity, the less change in rates.  Finally, there the unspoken dynamic of Trump and his bully-like tweets about keeping interest rates low, and how the Fed should respond to that…and more importantly…how their response will be viewed by the public. It’s a very complicated situation, which makes it even harder to trade and make money out of at this late stage in the game.

So what should you as investors do, given all these variables that may potentially affect the markets? The easy answer is to keep it simple.

First of all, we’ve already determined that we are in the late cycle. Valuations are lofty across the board and it is unlikely that equity investors will be able to squeeze much additional performance out of this market in the foreseeable future. We’ve also determined that though part of the yield curve inverted last week, we are still some time away from a recession. Bond yields have yet to peak and we should expect some further short-term capital losses on bonds in the interim.

Sooner or later, the absolute level of risk-free rates will become attractive enough that money will start to flow out of risky assets back into risk-free assets.  This is what is known as a “flight to safety” and it usually happens at the start of any major downturn.

So as an investor you should be looking to take advantage of this inversion and target the short end of the curve (2s are paying nearly 3%…I mean come on, have you seen how bad hedge fund returns are this year?!). The other thing you can look to do as a private investor (not a bond trader) is to invest in some higher yielding investment grade bonds that are due to mature in the next 2-3 years. In reality, the resounding warnings about a fallen angel crisis (investment grade bonds that get downgraded to junk status) are a bit overdone as the risk of this actually happening in the near term is slim.  Actual defaults in the credit market are unlikely to happen until we hit a recession and we’ve already determined that this is months away from happening.

Obviously, one must be prudent when picking the corporate but for the most part, investment grade companies will be just fine servicing their debt obligations in the near term and if you aren’t trading these things around you’ll be just fine holding the bonds to maturity, collecting a nice yield and not worrying about the price of the underlying like you do when trading a stock which sits much lower in the capital structure of a company anyways.