Bond Tantrum or Schnitzel Tantrum
David R. Kotok
Cumberland Advisors, May 14, 2015
“tan’trum, n. [earlier form tantarum suggests pseudo-L. coinage on tantara.] a violent, willful outburst of annoyance, rage, etc.; a fit of bad temper.” Source: Webster’s Deluxe Unabridged Second Edition.
Tantara is the Roman word for the blast of a horn or trumpet. The word tantrum has its root in war. The modifier taper was added in 2013. It has its origin in Ben Bernanke, the Fed Chairman who coined taper’s usage in financial lingo. He used the word taper and triggered what is now established as a bond market rout and a stock market sell-off. The taper tantrum of 2013 is now a term of financial history.
The following link takes you to a chart of a 10-year government bond tantrum. Many thanks to my colleagues Nannette Sabo and John Mousseau, who have been engaged within our firm in a multi-dimensional chat and research discussion about the very recent tantrum. Here is the link: www.cumber.com/content/special/sg2015051353615.gif .
The chart shows the post-2009 market recovery period during which the 10-year German benchmark government bond yield is compared with the 10-year US government benchmark yield. Notice how tightly correlated they were for three years. Notice what happened when the Fed actually tapered in 2014 and when the Fed started to reduce the duration of its holdings by allowing maturities of existing holdings to be replaced with some shorter-maturity assets.
Recall that the European Central Bank (ECB) was trying to get to a quantitative easing strategy and had to wait for legal decisions. And recall that Switzerland was supporting the euro by fixing its foreign exchange rate and absorbing euro assets onto the Swiss National Bank’s balance sheet. See the recent piece by Alex Pollock discussing the losses taken by the Swiss after they abandoned that strategy in January of this year. http://www.cumber.com/commentary.aspx?file=051515.asp
Conclusions. We have watched a 10-year government bond tantrum. It is rooted in the German bund, the nickname for the benchmark, euro-denominated government bond in the euro system. In our interview with Alix Steel on Bloomberg TV on Tuesday we called it the Schnitzel tantrum. We stand by that description.
The movement of these interest rates is being determined by several central banks’ actions. They have altered market liquidity by QE. They have moved duration onto their balance sheets and therefore withdrawn it from the market. That means the remaining duration in the market is subject to more volatile moves. Market agents do not understand this. Duration is a very complicated concept. We think of it in terms of years of maturity, but it really is a measure of the price sensitivity of a bond to a change in interest rates. When rates are low, as they presently are, the price sensitivity is very high because the duration is long. The 20% price adjustment in the Spanish 50-year bond is a good example. When markets wanted to own it, it shot up in price. When markets wanted to sell it, there were no buyers, and it collapsed.
At Cumberland, we see such volatility as an opportunity. Retail bond investors are puzzled and fearful. I personally see this repeatedly and discuss it with clients who reflect it on a daily basis. They see the vol, and they want to know if they should sell all their bonds. Then they see the vol in recovery and thank us for talking them off the edge of the cliff.
Here is our forecast.
The combined major central banks of the world have tripled their assets. They did this by buying duration from the market. They lowered interest rates to zero in the short end and suppressed rates in the intermediate and long end. They raised volatility. Now they face two elements.
First, they are not in sync. Europe is lowering rates, expanding its QE, and lengthening its duration. America is going in the opposite direction. Others are unclear. This means more vol than we are used to. And for asset managers who understand duration (and convexity, which is a very technical term in bond management, and I will save it for another day) this is a great opportunity.
Here is one example. On the day the 30-year US Treasury tanked for the reasons discussed above, it was yielding 3%. That bond interest is fully taxable for an American citizen. On the same day a tax-free housing authority bond from a major state sold above a 4% yield. It was backed by mortgages guaranteed by the federal government of the United States. Clearly this upside down and backwards distinction was not due to credit. Both credits were the United States of America. And clearly it was not due to duration of the specific bonds. Both are longer-term.
The reason for this upside down world is that the set of investors who are trading and using the 30-year Treasury are an entirely different set than those who are buying tax-free bonds. So the Treasury price and yield are determined by worldwide institutional buyers, sellers, and traders. The tax-free bond is priced by market agents who are about 25 million US high-tax-bracket investors, and they do not understand what is happening in their market, so they are immobilized.
Meanwhile, the ECB is the single most powerful force in global central banking right now. The ECB is currently the 800-pound gorilla, and the Fed is talking a lot but not acting. The Fed is sitting on the sidelines while it slowly withdraws duration from its assets and transfers that duration back to the market.
Look at the chart again. Look how violent the bund reaction was. We expect more violence and more tantrums. And we expect the ECB to stay its course regarding QE for the next year. That will extract more duration from the global market. The ECB will absorb the entire duration produced in euros during the next year. That will mean the Fed must proceed very carefully in liftoff because the Fed is dealing with a large force that is totally beyond its control.
As for tax-free bonds in the US, they are yielding over 4% in the highest levels of credit quality, and we are buying them for our clients. They are cheap.
Tantrums can be good things.
David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors