What's Driving the Bond Market Bloodbath?

0:08What's driving the bond market? Welcome to Real Vision Daily Briefing. It's Monday, October 23, 2023. I'm Ash Bennington, joined today by Christophe Olari, founder of Olari Consulting. A quick note before we get started to our Real Vision members, we have rolled out our new Real Vision 2.0 platform. So check your email to get on the platform. There's some amazing new features you're going to want to check out. I've been playing around with it for a couple of months, and it's really cool. Christophe, couldn't be more excited to have you with us here today. You've been looking at these markets. You're a big picture thinker.

0:42I was reading your research note earlier in the day. Obviously, historic route in the bond market. Big picture. Where are we? How do we think about it? How do we contextualize everything that seems to be happening at this regime change moment? Thank you, Ash. It's always a pleasure to be on our vision. I really think that after COVID, we tend to think that the measures put in place by the authorities will have the same impact as the ones put in place after GFC. and that, by definition, it will not be inflationary and we will have the same low rates and suppress risk of 10 premium and very settled markets.

1:32I warned at that stage that there was a big difference. The big difference was it was not only a monetary support, It was as well a fiscal very unprecedented support, which was coupled with the monetary safety net, which makes a big difference because contrary to post-GFC, the cash didn't go only into the, I would say, financial markets and risk assets. that went into the real economy, creating excess savings on the household, as well giving the opportunity for the large corporates in the U.S. to front-run their funding needs in 2020 and 2021 and making the most, in fact, of the year low yield.

2:28I think that the most important difference, and you can see it on one of the graphs I sent you, it's everything looks like, you know, part GFC at the beginning, and then you have a very big inflection point. What is a big inflection point? It's as the money is going into the real economy, the velocity of M2 is picking up, which means that the real economy is benefiting from the safety net delivered by the authorities in the aftermath of COVID. And you see that on this graph, that as soon as V is inflecting, in fact the bond market is getting the message, we have a different setup. If you add on to the mix, the fact that COVID and the invasion of Ukraine by Russia also just impaired globalization, destroy the supply demand, the need for the Western democracies to reshuffle their supply chain.

3:38I know I've insisted a lot on the reshoring. So, being sure that your network and your suppliers are getting closer to your country, based on suppliers that you can trust. So, now you need friends as suppliers. And this has a cost as well. So, in fact, we shifted to, you know, remember after GFC, the military support has been used by the government to deliver. Like each single press conference from Barrio Draghi was about, was about, please guys, just make the most of our lawyers to implement, I would say, a big push, a fiscal push. What Germany did, for example, they went from 2014 to 2019 from a budget deficit of 3 % GDP to surplus.

4:43And instead of using the low yield to extend the duration of the debt and to put in place ambitious fiscal measures, they deluge. And what are they doing now? In fact, they are expanding their deficit with a yield at 3 % in the joint. So I think that what is very important, I think the fiscal change is not a blip. I think it would persist in the mid and the long term for many reasons. First of all, we spent months after COVID telling all the voters that deficits don't matter anymore. We can expand the deficit. It's not a problem. That's why you don't have the Regardium imbalance unfolding at the moment.

5:39What is the Regardium imbalance? It's when you're a household or consumer, at one stage, increasing deficit becomes counterproductive because the consumer think about the future tax rise. At the moment, nobody thinks about that for one reason. Everybody has said for a person during one year, deficit don't matter. So I think that the consumers would expect more fiscal larges for longer. Then you have the reshoring. So really inventing your supplier network that will have an impact on the fiscal deficit, obviously, re-arming in a world which is extremely antagonistic, and the energy transition, which is as well, will have a cost.

6:34Christopher, I want to show some of these points visually to our audience, because what you're talking about here is just so important. You know, over the weekend, I was tweeting about the deficit, and the quote that I said was, deficits don't matter at all until they matter very much. And it is this moment that you feel the earth shifting underneath your feet. You have three really great charts here I want to take a look at. First, let's take a look at the great escape chart. This is the overview of what's happening in interest rates. Take a look at this. This is U.S. Treasury. If we can bring that up on screen, Brian.

7:06Christophe, what are we seeing here? We see, in fact, the 40 years of secular depression here dynamic. In fact, where does it start? It starts essentially at the end of the 80s, where you had the Volcker, you know, painful normalization at the beginning of the 80s. And then in 89, you brought the fall of the Iron Curtain, which has bring a lot of, you know, cheap labor force in the market. And then you have the acceleration in 2001 with the ambition of China at the WTO. So, but that's a very steady decrease of long-term yield. One reason being, again, post-GFC, only monetary push, which I always believe in that.

8:01You know, when you look at the negativity as head policies, like in Europe and Japan for seven years, I think it's deflationary because it supports wrong allocation of capital. It keeps alive the production entities that should not be able to produce anymore. So I think those policies were deflationary. And then you've got the inflection point with the very, very brutal inflection friction and the breakout of that channel, which is the consequence of the fiscal push post-COVID. And then the election of Biden, and what we call the big friction dynamic. Christophe, at the very beginning there, you said something very important, which is 40 years.

8:53This really is a true regime shift. If you look back on the 10-year Treasury chart, it peaks around 1981 at just shy of 16 % or thereabouts. This is something that if you're under 65 or 70 years old and you're working on Wall Street, you've just never seen before. That breakout that we see on the right-hand side of the screen. Yeah, but you know it's quite amusing because I was looking at the graph on the weekend when I prepared the presentation. And when I started at Lehman at the end of 1993, we were at 8%. And in fact, the year, the current 5 % is essentially the average of the 10-year yield pre-GFC.

9:37So, you know, my view is, what was the normalcy? Is it the 5 % today or was it the suppressed yield regime that we had for 10 years? I think it's one of the bigger insights of the last six months. We are learning, we are rediscovering price discovery. We've been in the market for 10 years. Every month, you know that you're going to have a decent purchase of bonds from non-sensitive buyers. they buy. So in fact, we talk a lot about the buy the dips on the equity market and the put of the Fed on the equity market. I think the real put was not on the equity market, it was on the bond market. Because you know that it was insensitive buyers present every day.

10:44So I do believe, I don't think that we're going to have an auction which is It's about to fail. I don't think that we'll have, you know, kind of seeing of the US government debt. I just think that we are in that dynamic where you've got more supply and the structure of the demand has changed. China is not buyer as much as before. In fact, in August, it was the biggest drop on the treasury resulting in 10 years, which has nothing to do with the geopolitical tension. It's just because August was a big, big pressure on the UN. So China had to sell US dollar assets to have dollar to sell to support the UN.

11:32And you have the Fed, which is out of the picture. And so I think that we are in the middle of that. Yeah, rediscovering price discovery, I think it's very important. Right. Right. Rediscovering price discovery. That might be something to copyright. Maybe I should get it as my first hat here. We're going to take a quick break and be right back with more of the day's top analysis on the Real Vision daily briefing.

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13:00Christoph, let's take a look at the next chart. This is just a little bit of a zoom in here on the prior chart. But the caption, I'm not sure if our audience can read it on screen. It says worst bonds draw down on record, on track to print a third consecutive year of negative returns. Price obviously moving inversely to yield. Yeah, we never had three years in a row of three consecutive years of negative returns on the bond market. That will be the first occurrence because I don't see the bond market recovering the losses in the last two months of the year. which has a big implication. The bond market has been the anchor, the pillar of any diversified portfolio.

13:49You know that it was breathing stability in your portfolio. It was a proper safe haven. And what has been remarkable over the last, I would say, six months, the bond market is breathing stability, which is not supposed to happen with no safe haven. and this is a note I sent to clients last week. Body has been very difficult since the escalation of the geopolitic tension in the Middle East. Where do you hide? What is your edge? The yen is not a hedge anymore because the yen is impacted by the monetary policy of the BOJ and has become not, it can be a hedge because it's the easy way to express a safe guy threat for the time being.

14:43Software and bonds didn't fulfill their usual safe role for one reason. It's hot data and the Fed keeping alive the idea of a longer narrative. So therefore you have three edges, which is four in fact. Galt, obviously, crude. You have this, but it's quite, it's a bit complicated because not complicated, but you need to have your timing extremely precise. And then you have cash. And then you have cash. Cash has become, do you remember when Ray Dalio was telling everyone that cash was trash? Cash was trash, but cash is kingdom. You are paid 5 % to have no risk. It's a no-brainer. Well, you know, it's so interesting because a lot of people who obviously do not follow these markets as closely as you do found that out with their 60-40 portfolios when they were getting whacked on both sides.

15:50But you mentioned something important, which is the third chart in this series, which is all about term premia. Talk a little bit about what we're seeing here on this third chart, Christophe. First of all, what is the whole structure of the 6040? It's your overloading in the asset, which has low volatility. In fact, the realized volatility of the TLT in October and September has been much higher, 12 points higher than the realized volatility of the S &P, which is absolutely unseen. What has been as well the pillar of the 6040, it's the positive correlation between the S &P and the U.S. yield. So it's a proper edge.

16:40Now we are at the most extreme negative correlation between the S &P and the U.S. So to go back to the term premium, there is a difference. The term premium is what is showing we are exploding for one reason. The market is concerned not only by the deficit, but the US government. So the question is, if there is a problem, do we have a US government able to put in place the necessary measures? And in fact, it sounds like a joke, but we see that the election of the successor of McCarthy shows that in this sea, you can question, is there a structure enabling quick answers if we need to sort out accelerated deficits or big issues about the future of the economy?

17:43of the fiscal outlook in the U.S. And I think that, you know, when Fitch downgraded the rating of the U.S., they insist on the deficit, but they put the focus on the U.S. government. And I think this is the biggest issue. Christophe, as you might imagine here at Real Vision, we're covering this from many different angles on the platform, especially. And I want you to take a look at a conversation between Roger Hurst and Michael Nicolettos. This is called, Is the Market Overlooking a Hard Landing? Obviously talking about some of the challenges that you see on the horizon. This is a conversation that aired last week on Real Vision's Plus tier.

18:23Let's take a look at this conversation. If we see a correction in China, it's not nothing. It's something and we need to pay attention. So this is what I would pay attention to right now. And I think looking at these things is very important in terms of how you invest in the coming years. And having said that, and I've been wrong because I've been buying U.S. Treasuries, two-year bonds since the beginning of the year. Actually, I bought cash and then buy future. But my argument was, I don't know where equities are going, but I'm being paid 4 % and 5 % to wait. So I haven't seen that for 20 years.

19:01I might as well get 5 % and wait until I figure out what happens in the world. And if there is a scare, then bonds will rally, equity will fall, and then you can shift your money into equities if that's the case. So again, I don't want to say, I'm not sure what's happening, but I think liquidity drives markets. And this is the reason that markets haven't corrected. Everyone thinks that liquidity is drying up. But the policies that the central banks have put in place in terms of getting the liquidity from the banks as collateral and giving liquidity, in different forms has kept liquidity at a much higher level than people think.

19:43Christoph, Michael Nicoletto is making some points there, very much congruent with what you're saying, particularly when he said, so he hasn't seen this for 20 years, I might as well get paid 5 % and wait it out until I figure out what's going to happen next in the world. Precisely to your point about this question of money on the sidelines, while the market anticipates and attempts to understand the regime shift where we head next. Yes, Andy, you know, it's an When you had some questions about the medium-term outlook at post-GFC, you were not rewarded to be patient because your cash was earning zero.

20:18So you were incentivized to take risk, obviously. But now, look at the spread between the one-month stability and the dividend yield of the S &P. We are at 15 years extreme. I just, you know, when clients ask me, what is your strongest trade idea for the next six months? I'm going to look stupid, but buy one month's TBI or two months TBI. If you don't have view, if it's too volatile, if it's the visibility is not good enough, which is a consequence of the central bank who are not giving you the usual forward guidance, guidance, which was a pillar of their communication for 15 years, you don't pay to be patient.

21:04So be patient and be paid. Yeah. What a strange regime shift from where we were, call it two years ago, a dramatically different point. We're going to take another quick break and be right back with more of the day's top analysis on the Real Vision daily briefing.

21:24Here's a question that I just wanted to get to because so many people have expressed this to me on Twitter. It's something that's been out there in the conversation. It comes to us from TrillionX Macro from YouTube. The question is, Christoph, with the start of a second proxy war, at which level on the U.S. 10-year yield do you see the Fed starting a YCC policy to stop the bond vigilantes? First, we should probably explain a little bit about what he's talking about here to the novices because this is such an important point. TrillionX is talking about room curve control, this idea that the Fed might lose control of the longer end of the curve, increasing the rate at which the U.S.

21:59government must finance its debt and needing to put a lid on it. This would be the first time since World War II. If that were to happen again, it would be a historic shift. I would just take a step back and I would just, you know, I think that a strong conviction is the low inflation volatility of the last 30 years is over. So I think that we are entering into a higher yield regime for the foreseeable future. So I think that we're going to go back to 2 % on a sustainable manner on the US CPI. No, I think that 3 % would likely be the new floor. So higher new regime in terms of higher rate regime in the future.

22:48At the same time, what I'm massively convinced is that the economy, the portfolio structure, the financial world is not calibrated for 5 % yet. And we talk a lot about R-star, the equilibrium rate. I think we don't speak enough about R-double-star, which is the financial stability rate. But this is the threshold where the Fed hacking campaign is starting to create chaos. I think we're not far away, to be honest. I think we're going to have more issues in the future. Don't forget that the track record of the Fed is absolutely exceptional. going from there is no tech bubble early 2000, early 2000, to there is no subprime problem early 2007.

23:44Remember that in February 2020, Clarida was saying that COVID was not an issue. And I think that higher for longer would be, we have a good place in the traffic order of the Fed. So it's a thing that we are getting there. but yeah there is certainly more website pressure first on the on the long end of the curve why is he seeing a curve controller i feel that the um i think it's too early first of all i think that five percent again for the generation has been used to one or two percent it's high but in the grand scheme. It's not the average of pre-GFC. So we're not there yet at 5%. No, we're not there yet because don't forget that there is an option, the first option that we can use before putting the bazooka because the yield curve control is the bazooka.

24:42It's the operation twist by the U.S. Treasury. So I think that by, you know, spewing the upcoming refunding towards the let's say five to seven years part of the curve and not to the long end, she can alleviate the pressure on the long end. It's Operation Twist Goes Nuclear, I guess you could say. Hey, listen, Christoph, there's one other chart that I want to show here because I thought it was so important. We've been talking about these historic reversions of cycles, some going back 40 years. We've been talking about a GFC cycle. This is a really important chart. This is the chart that you have, and it's such a striking one, of negative yielding fixed income instruments going from$18 trillion at peak in 2020 back down to essentially zero.

25:30I think the number on the lower right-hand corner of that chart is 35 million. I remember when this started ramping up in the wake of the global financial crisis. It was something that all of the wonks in the space were talking about. And here we are watching it all roll off. Eric, you know, I think I agree with you. For me, it's one of the most... ridiculous some weather chart because when we were at the peak at 18 trillion, you had high yield in Europe issuing negative interest rate. And when you think about it, that's absolutely nonsense. It's anomalous. So that's why I think that these ultra-comunitory monetary policies, negative interest rate policies has forced investors to go down the quality ladder and to pick up anything, to create the zombies, those, you know, empty structures that were kept alive by flooding cash into the system.

26:36And that's why we went to 18.3 and I think that when you look at the setup, that's quite healthy, that we are going to something which is more sensible with the, you know, the, the, the, the reality. Christophe, what have I missed here? We've obviously covered a tremendous amount of ground. One of the things that you mentioned that's mentioned in your note is the impact of what's happening over at the BOJ, the Bank of Japan in the post-Hideki Kuroda era. This is something that's a little abstract, I think, for people to understand. Tell us what's happening there and why it matters to investors, particularly in the US and Europe.

27:17I think it's a very important point. What has been a big tailwind for the NASDAQ and the US Treasuries? The negativity as red policy of the BOJ. Because you had capital outflows from Japan into the US, especially for the life insurance, Japanese life insurance. If we, if the BOJ, I think it's not if, it's when the BOJ abandon the yield curve control and go back into a normal monetary policy with low rates but not negative, I think the biggest risk is to see that repatriation from funds that have been invested in dollar asset back into Japan. Talking with lifers in Japan, the thresholds will be around 1 % on 10 years and 190 on the 30 years.

28:15We are getting there. And that would be interesting because that's going to be a big, big, big, big, um, disabilizing force for the U.S. asset that have benefited from this reallocation from the Japanese investors. Christophe, such important work as we all try to get our heads around the big picture of what's happening here today, getting out of the noise of the day-to-day news cycle, what we love to do at Real Vision, what you do so well. As we talk about this shift from structural tailwinds to structural headwinds, final thoughts, key takeaways that you'd like to leave our listeners and our viewers with?

28:52But the upcoming month, I think the reality, in my opinion, is the bond market will remain essentially volatile and pressurized. That will require the Janet Yellen to implement the operation twist. But the big question remains for me, what if the bond market doesn't rally when a recession happens? In fact, we are all particularly optimistic. It's recession, we're going to have the same dynamic, safe haven, and a bullish tipping of the curve, but long-term yields, rallying, just collapsing. What if, in fact, the market assumed that the answer to the recession would be essentially fiscal and not monetary?

29:50And that's maybe the most important question, because it means that the recession would not necessarily be good news for the long end of the bond market. I don't have the answer because I'm not sure that we can push the deficit in any way. way, but I think that maybe the market will punish the long end of the curve initially and I'm forcing the Fed to implement the yield curve control. I don't think that the yield curve control is a completely out of the blue idea. I think it's a possibility of, I would price it at 10 % at the 10 billion, but I think that - 10%. 10 % problem. I think that we're going to have the operation twist, but I think that if the bond market doesn't react, the way it should react to a recession, I think it's going to become a much higher probability.

30:44And what I love, which I find super exciting, is having yield curve control in the US when the BOG abandons the yield curve control. It feels really big chaos. And a big cash flows disruption and in fact shift. And we need to be, I think it's not have any possibility. Christophe, it's always a pleasure when you join us, but especially a pleasure as we seek to contextualize everything that's happening in markets across the world. Christophe Alari, thank you so much for joining us. It's my pleasure. Thank you very much for inviting me. Thanks so much for watching or listening to Real Vision Daily Briefing.

31:23We'll be back tomorrow at 4 p.m. Eastern time, and we're going to leave you with this very exciting announcement from Raoul talking about cool stuff. You're going to like this one. Have a good day, everybody. Crypto is a very complicated space and it requires a lot of understanding, not only of the crypto markets, but how it fits into the broader macro landscape.