Safe-haven sovereign bonds are experiencing a counter-trend snapback rally as the focus has shifted to a slew of troubling yet still mostly second-tier geopolitical events.
The incoming populist Italian Five Star Movement/right-wing League political coalition is pursuing a shift away from painful austerity back toward the type of popular but damaging heavy borrowing and spending regime that led to Italy ballooning its debt to an increasingly dangerous 132% of GDP. Let’s not forget there was a European periphery debt crisis brewing near full steam just 3-5 years ago. Political developments in Italy have caused periphery bond yields to diverge starkly from those of German Bunds and US Treasuries. Jittery capital has left the likes of Italy, Portugal, and Spain for Germany and the US.
For the most part, we consider Italy’s political risks to remain contained in terms of their propensity for igniting a wider systemic crisis. The populist coalition doesn’t have anything close to a mandate for something as severe as leaving the EU or euro currency. It is far too premature to give any Italian political coalition much credit this early on since they are historically so prone to falling apart before implementing an ambitious campaign agenda. It is worth monitoring closely but not running for the beautiful hills of Tuscany.
Debt strained and politically challenged emerging markets such as Turkey, Argentina, Venezuela, and South Africa have been witnessing (or already witnessed) massive capital outflows. The yield chasers of yesterday are all of a sudden less interested in financing frothy debt. We warned of this here. Idiosyncratic political risks are easy to identify in each case, and evidence of contagion fears spreading to other guilty-by-association EM markets is beginning to creep in. But not to the level of hysterics displayed by Keynesian ideologues in order to justify their predisposed desire to fix every problem with the same failed remedy like a wind-up doll who cries “print money and devalue the currency!” when you pull its string.
The final straw to shake a heavily offsides positioned cadre of US Treasury short sellers was Mr. Trump canceling his eagerly anticipated Singapore summit with North Korea’s Kim Jong Un. As if UST short sellers needed more problems, one more shoe dropped today as OPEC indicated it may be flinching on maintaining its current oil production cut pace.
That’s where we are. So where are we going?
We see the risk/reward for holding long positions in long-end US Treasuries and Bunds as uncompelling. We’d rather fade this bond rally and take profit on dips. Chasing bear market snapback rally momentum after a big spike has already occurred is not a valid long-term business model for asset managers. Maybe you get lucky here and there with three sigma moves that you didn’t join until after two sigmas. We’ll take the other side of that trade on a consistent basis over a long period of time and swallow the occasional lumps.
The featured chart in this piece is a reminder that leading economic indicators such as regional Fed surveys are indicating a surge of supply chain price pressures that will continue feeding into PPI and then to a slightly lesser degree perhaps CPI. We see at least a calendar quarter of CPI beats ahead of us. Should that occur, it will not give bondholders warm and fuzzy feelings about holding assets decaying in purchasing power at a faster rate than expected at levels already above the Fed’s supposed 2% target–a 2% target by the way, which they are already shying away from defending. US deficits and QT are also accelerating issuance and supply. Bondholders will demand a higher rate of return, and thus lower bond prices.
The primary risk to our thesis is if we have already begun a synchronized global slowdown that will accelerate and turn into something much nastier right away. That is bound to happen in some form sooner or later but if we are not knocking on that door right at this moment then selling the bond rally is a better risk/reward until such a time when we are in the throes of a global deflationary bust. Risk manage accordingly. This is an opinion piece.