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The next impossible

Today, in an effort to punish me for musing that a short squeeze might be on into the weekend, the worlds G10 fixed income markets sold off all pretty much in parallel. Treasuries, Bunds, Gilts, JGB’s… It didn’t matter. Everything came off, both real (inflation adjusted) and nominal rates rose across pretty much ever market. Except the front end of the Euro curve – where whilst nominal rates rose a bit, real rates fell. I’ll come back to this. Remember that a few months ago – this was impossible. Rates were never going up anywhere.

Why are real rates rising across the world at the same time that stock prices are going up?  All other things being equal, higher real rates should mean lower stock prices – but the bullish sentiments unlocked by the “Trump = Reagan” narrative mean that this relationship has broken down. In fact, to say its broken down gives it a false credibility – it’s a relationship that’s more theoretical than practical. Investors don’t look at bond prices and use that to discount the future earnings of the companies they’re buying in order to assess whether equities represent good values or not – they simply buy into and out of narratives – “Risk on” means you need to sell bonds and buy stocks OBVIOUSLY – and no, it doesn’t matter whether you have a fundamental rationale to do either trade-  you just have to because the inverse correlation is self fulfilling – if you own stocks, you’re vulnerable to a rally in bonds. If you own bonds, you’re vulnerable to a rally in stocks. The market doesn’t know what’s driving the “animal spirits” of risk on risk off -but its damned if it’s taking its time to find out.

But whilst today we saw that the risk on narrative is raising real rates everywhere in the world, it can’t seem to touch the front end of the European market. “Ah but QE!” – yes I know that – but as you surely know, dear reader the ECB is running into a brick wall in terms of bonds to buy soon and anyway, the market is so desparately short of collateral that they’re mooting (and banging newswires with) schemes to lend out the bonds they bought. But wasn’t the point of QE to swap bonds for money to help the economy???? Quite. Anyway you can’t do impossible things for ever and the ECB will not – and who remembers what happened when the Fed tested the waters about tapering bond purchases back in 2013 ? Clearly not many people. 5y bunds are trading at -40bp – which is the same as the ECB’s deposit rate.

Now is the ECB going to withdraw asset purchases overnight? no. But is the market going to believe that they’re going to keep monetary policy accomadative when they inevitably have to change the rules either in December or January? History implies not. The ECB is an institution riven with conflict, the market is pricing the next 5 years with policy as loose and accomadative as is mathematically possible. All it takes is that probability distribution to shift and those holding 5y paper yielding the same as the overnight deposit rate are going to be 5years worth of worried all at once. That’s the magic of fixed income markets. God I love them so.

 

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