Deciphering the Message from the Bond Markets

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This week’s report is a little shorter than usual due to both non work commitments and also a sense that our market views are slightly out of synch with what is actually happening. This occurs from time to time and is a fact of life in financial markets which we shouldn’t be afraid to admit. Let’s hope we feel better attuned very soon!

There is no one single indicator that tells us what direction markets will take in the future, however, the message from bond markets can often be informative. The last two months has seen a marked decline in core Government bond yields and curve flattening, especially in the US and UK. We could take this message as one of caution on the economic outlook or are yields softer due to temporary factors?. Frankly, we are not sure as there are cyclical and structural factors that influence our thinking either way.

In the chart below, we show both US Real GDP (year on year % in red) and the yield curve as measured by the difference between 10 year and 2 year bond yields. As noted, we have advanced the yield curve by 12 months. What we can take away from this chart is 1) when the US yield curve inverts, there is a strong probability of a recession beginning in the next year or so, and 2) robust growth usually occurs after the yield curve has steepened, and vice versa.

Chart 1 – US Yield Curve (10s 2s) and Real GDP

The flattening of the US yield curve in recent weeks has occurred with 10 year yields falling more than 2 year yields, with the respective declines about 35 basis points and 15 basis points from the early July high. With recent economic data generally in line or better than expected (as measured by the Citi economic surprise index), either the bond market is sniffing out economic weakness ahead, or is reacting to short term dynamics that could dissipate. Perhaps the declining inflation rates in recent months, coupled with dovish central banks everywhere (except Canada) and geopolitical concerns are encouraging investors to bid up prices (yields lower).

Of course, we have no real way of knowing whether geopolitical concerns will spill over into something much more serious, but we can assume that any short term economic disruption from the two major hurricanes to strike the US in recent weeks will reverse as the rebuilding and repair process kicks in. What we think could well happen is that the Fed will potentially remain quite dovish as the economic data becomes quite “noisy” due to the effects of the storms, but at the same time, inflation could very well be heading higher into year end and early 2018. The trouble is, we cannot be sure what the reaction of the Fed will be to this potential scenario as Trump has to appoint both a new Chair and Vice Chair in the next few months.

What we do think is key at this juncture is that markets are simply not pricing in any economic improvement or increase in inflation, and are barely pricing in any Fed rate rises over the next 18 months. In our view, the risk/reward is very much skewed towards higher yields in the months ahead, although we have to admit that fighting the trend in the bond market and calling for higher yields is not exactly a strategy that has worked well in recent years.

It is somewhat frustrating that our conviction levels are so low on this bond market view, because we think a turn higher in yields would be very important for all financial markets. Certainly, the falling US yields have been a major headwind for the Dollar of late, and have been helpful for equity markets. We have been looking for a turn in all three assets; higher yields, stronger Dollar and weaker equity markets, and with mixed success. We have also been thinking that the turn should be happening right about now, i.e. heading into Autumn. Simply put, the next few weeks are important to this overall view.

Summary of trade ideas highlighted in our weekly commentaries

A tough week for some of our trades. We were finally stopped out of our short German Schatz trade and also the two bullish US Dollar trades from the week before. As a result, our realised profit/loss has declined.

Our two remaining positions reflect our bearish US equity view. We wish to see these trades move quickly in our favour. If they don’t, we will likely exit them and move to the sidelines.

                     
  RMG Trade Idea Summary – Initial Notional Portfolio of US$5 million
  OPEN TRADES
Trade

Date

 

Trade

Entry

Price

Stop Loss Level Loss to stop Local Curr Loss to Stop US Dollar Bps Risk to Stop Last Price Open P/(L)% Open P/(L) Local Curr Open

P/(L) US Dollar

15/08/17 Long 300 November VIX 16/24 Call Spread 0.97 0 -29100 -29100 58.2 1.05 8.25% 2400 2400
23/08/17 Long 20 Contracts S&P 500 November 2350 Puts 29.2 0 -58400 -58400 116.8 22.4 -23.29% -13600 -13600
  Unrealised Totals -$87,500 -$11,200
  CLOSED TRADES
Trade

Date

 

Trade

Entry

Price

Stop Loss Level Trade

Closed

Close

Price

Realised

P/L

  US Dollar P/(L) Last

Price

Open

P/(L)

14/07/17 Long 10 Contracts Sept Cocoa 1892 04/08/17     2047.7 8.2% 15570
14/07/17 Long 10 Contracts Sept Cocoa 1892 01/08/17 2068 9.3% 17600
14/07/17 Long 20 Contracts Oct Sugar 14.099 04/08/17 14.174 0.5% 1680
14/07/17 Long 10 Contracts Sept Coffee 132.10 04/08/17 139.4 5.5% 27375
19/07/17 Long 20 Contracts Sept Cocoa 1943.10 28/07/17 2035 4.7% 18380
19/07/17 Long 20 Contracts Oct Sugar 14.42 01/08/17 15.0245 4.2% 13541
20/07/17 Long 10 Contracts Sept Coffee 136.175 01/08/17 138.65 1.8% 9281
09/08/17 Long 10 Contracts December Gold 1274.4 14/08/17 1287.4 1.0% 13000
02/08/17 Long 40 SPX Sept 2400 Puts 12.7 14/08/17 12.3 -3.1% -1600
29/08/17 Long 5 Contracts S&P500 2446.5 31/08/17 2464.5 0.7% 4500
30/08/17 Short 10 Contracts September VIX 13.2 31/08/17 12.9 2.3% 3000
29/08/17 Long 5 Contracts September S&P 500 2446.5 01/09/17 2474.25 1.1% 6938
26/07/17 Short 100 Contracts September Schatz 112.03 05/09/17 112.29 -0.2% -26000 -30976
01/09/17 Long 1.5m USDCHF 0.96 08/09/17 0.9481 -1.2% -17850 -16924
01/09/17 Short 1.5m NZDUSD 0.7166 08/09/17 0.7305 -1.9% -20850
Cumulative Closed Profit/(Loss) $60,515

This is not meant to be a model portfolio and it is not meant to constitute any investment advice. This is purely a way of keeping track of specific trade ideas that we highlight in our weekly investment commentaries. These ideas will consist of the more important or higher conviction ideas that we implement in our multi asset macro fund. We have chosen to have a notional starting portfolio value of US$5 million; the reason being that we can then also illustrate how much risk we are taking on each trade as well as keeping a cumulative track of how our main trade ideas are performing. This is a notional portfolio only and does not represent any portfolios that we manage. However, for the sake of clarity and consistency, we do put these trades into our multi-asset macro portfolio alongside other trades that we do not make apparent here. The prices we show in the table above are the prices we transact at for our macro fund, not including any trading expenses.

 

Stewart Richardson
RMG Wealth Management

 

 

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