More to the point, the VIX is now at an all time low, indicating that it is being sold in light of the expectations of the Fed response and buying plans. At the same time we have yields on Treasuries that are incredibly low.
VIX will rise 10X faster than it went down, rates can't hold and keep the bond market alive, this is going to be interesting..at least along the lines of riding a 100mph roller coaster!
One of the more obvious side-effects of Ben Bernanke's simplistic QE2 plan is to force retail investors out of their existing trajectory directed at fixed income products, and back into stocks, so that retail can once again occupy it long-coveted (by the bankers) position of buying Apple and Amazon at triple digit forward multiples. Unfortunately, as JPM's Nikolaos Panigirtzoglou explains, all that QE's lowering of bond yields will do (in addition to sending soybeans limit up every day for the balance of 2010, despite what others claim is merely a hallucination) is "reinforcing retail investors' flows into bonds." The biggest problem with the secular shift away from equities, and into bonds, is that the very mindset that the banking cartel loved for so long: retail buying stocks high, buying even more higher, has now translated completely into bonds. As JPM says: "The more bonds rally, the stronger the buying of bond funds by retail investors." In addition to the daily flash crashes in now countless names, surely this phenomenon explains why retail investors have taken money out of stocks for 23 weeks now (leaving many mutual funds running on fumes and a prayer) and put it into the best performing asset category (after precious metals of course). And QE2 will cement not only retail, but institutional demand for bonds as well: "lower bond yields are widening the deficits of pension funds in both the US and Europe inducing them to move further into fixed income to reduce the mismatch between assets and liabilities... This raises the risk that these institutional investors will move more towards corporate bonds in search for yield. So a potential aggressive move away form government into corporate bonds could exert strong downward pressure on credit spreads." Suddenly the world will realize that the average duration on rate-based exposure is 10+ (especially if Mexico issues a few more 100 Year bonds). And when rates creep up even a tiny little bit, it is game over as the next negative convexity event will be the (credit) market itself. Which is why we have long said that the black swan is not a failed auction, but the merest hint that rates are finally starting to creep up.
More from JPM on this psychological quandary, so very troubling for the Federal Reserve, as well as on other "unexpected" consequences of QE2. Pay close attention to where JP Morgan spits in the face of so many CNBC idiots, and flatly ridicules the whole money on the sidelines bullshit:
By lowering bond yields, QE is reinforcing retail investors’ flows into bonds. Retail investors flows into bond funds tend to be a function of past 12 month returns (see Chart 1). The more bonds rally, the stronger the buying of bond funds by retail investors. Bond funds have generated impressive, close to double digit, returns for second year in a row and the continuing decline in yields is increasing the attractiveness to retail investors. Even if bond yields stop declining and bonds returns become coupon-like, i.e. 2-3%, retail flows into bond funds are unlikely to turn negative. To a large extent bond funds are benefiting from a structural move away from money market funds as the implosion of SIVs and the Lehman crisis dented investor confidence in money market funds. In addition a cyclical environment of close to zero short rates, makes money funds or bank deposits unattractive relative to bond funds. Bond fund returns will likely have to turn negative for retail investors to start selling them. This requires a significantly rise in bond yields, something that it is unlikely to happen as long as QE is underway.
QE is also reinforcing institutional investors’ demand for bonds. As shown in the section below, lower bond yields are widening the deficits of pension funds in both the US and Europe inducing them to move further into fixed income to reduce the mismatch between assets and liabilities. At the same time historically low bond yields are making both pension funds and insurance companies thirsty for yield. This raises the risk that these institutional investors will move more towards corporate bonds in search for yield. And their buying power is big. As Chart 2 shows, pension funds and insurance companies typically buy $100-$150bn of bonds per quarter. So a potential aggressive move away form government into corporate bonds could exert strong downward pressure on credit spreads. The search for yield induced by QE creates a sweet spot for credit.
- QE is also causing a decline in the US dollar forcing EM policy makers towards more intervention. One form of intervention is for EM policy makers to prevent an appreciation of their currencies by acccumulating foreign currency reserves (e.g. China). Because these reserves are typically invested in US and European government bonds, this exacerbates the bullish momentum in core bond markets. Another form of intervention is to impose taxes on investment flows especially those in bonds (e.g. Brazil). This forces DM bond investors, who were hoping to get an extra yield in EM bond markets, to retrench back to their own bond markets, again exacerbating the bullish momentum in core bond markets. In the 2010 survey on European pension fund allocations intentions by Mercer, the biggest shift was towards EM bonds. This shift is now becoming more difficult following a renewed wave of EM policy intervention. It appears that a “currency war” has already began in EM, and the refusal of China to revalue its currency makes it more likely that EM interventionism will intensify rather than subside from here, amplifying the buying flow in core bond markets.
- QE is establishing the dollar as a funding currency for carry trades. The dollar carry trade has intensified more recently as shown be recent flows and positions in the section below.
- QE is creating a regime of low bond yields but also higher uncertainty. At the least, QE makes central bank exit more difficult and raises the risk of a policy error. Higher uncertainty boosts demand for assets such as gold, which has become to the eyes of high-net worth investors, the ultimate hedge against tail risk. ETF holdings of physical gold reached a new record at the end of September.
Lower bond yields as a result of QE make equities more attractive from a valuation point of view, but we think a sustained move away from bonds into equities is improbable. First, as explained above, for retail investors to change their buying pattern, absent a significant rise in bond yields, which is unlikely as long as QE is underway. Second, higher uncertainty makes it less likely that corporates will engage into large-scale debt-financed equity buying. Cash holdings are high among corporates but so is net debt (see Chart 3). [YES LADIES AND GENTLEMEN, EVEN JP MORGAN IS REFUTING THE MONEY ON THE SIDELINES LIE]. Elevated cash holdings do not have to be deployed into equity buying. They can be used to repay debt. Or elevated cash holdings might reflect a new desired level of liquidity given that memories of Lehman are still fresh. As explained in Flows & Liquidity Sep 24, corporates tend to become active buyers of their own equity later in the cycle, 2-3 year after the expansion begins.
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