During the last few weeks we saw the stock market gyrate with wild swings up and down. Investors started thinking “crash” mode. In times of crisis we need a clear head and logical thinking. First, let’s look at who is doing the buying and selling. The US Federal Reserve gave the big banks 4 trillion to play with when they set in motion their bond- buying program. It lasted from 2009 through 2013 and will end this year. (When the Fed buys bonds it credits banks’ balance sheets.) The banks used this money to rally the stock market to new all time highs. So, this was a ‘big boys” rally. Individual investors have been largely absent in this bull- run. The selling and buying that occurred was largely driven banks and hedge funds. You are probably wondering what this has to do with the bond market.
The bond market is three times larger than the stock market. PIMCO is the largest bond fund in the world with 2 trillion under management. When the selling occurred recently, the large chunks of cash moved into the bond market for safety. This created a bond market rally at a time when the media and analysts were looking for interest rates to rise. The benchmark 10- year note rate fell to under 2.5%. The shorts-mainly banks and hedge funds- got caught flat- footed and had to cover. This drove the market even higher. Now, at a time when rates should be rising, we have the opposite scenario occurring. Prices are going up and rates are dropping.
There are other factors lurking in the shadows. With interest rates near zero, banks and hedge funds started looking for higher yields. They loaded up on junk bonds that pay higher interest. The problem is that these securities are illiquid. They are difficult to unload when there is a panic. There are no bids and the market is frozen. We’ve seen this in 2008 when banks and hedge funds could not sell their CDSs and CDOs. This is why the Fed stepped in and started creating liquidity with their QE programs. Now, however, the Fed knows that in a crisis they cannot repeat another such program. They have started a mock crisis by investigating the extent to which banks and hedge funds can sustain heavy bouts of selling.
There is still another factor that is confounding the problem. When the Fed announced its buying program it stated clearly that they would be buying long- term 30- year bonds. This was aimed at keeping mortgage rates low and stimulating the housing market. This was a clear signal to banks and hedge funds-buy long term. They often hedged their positions by selling short term paper. By and large they are still hedged. The problem is that when rates do go up and selling starts, the long bond will drop faster. The Fed has little control over this end of the curve.
So, what we have is a giant bond bubble, the likes of which have never been seen in history. Chances are that selling will not be orderly and panic will set in. This is why investors must watch the bond market for clues that will affect their portfolios. Always remember that most mutual funds like to spread their risk by hedging their stocks with bonds. Selling in the bond market would directly affect 401ks. Unlike hedge funds, mutual funds cannot short the market in times of panic.