Bonds in the New Normal

The ZIRP/QE era was the biggest anomaly in financial history.  It lasted for over a decade, so it left a lasting impression on fixed income investors, who are still adjusting to the new normal.  The distortions created by ZIRP and QE make investors view 10 year bond yields at 5% as being very high.  But a 5% 10 year yield would have been considered very low from the 1970s to the 1990s.  Looking from a big picture historical perspective, ZIRP/NIRP was insane monetary policy.  Paying people to borrow money, or letting them borrow for free is insane in a fiat world of ever increasing money supply.  

I remember back in 2009 and 2010 when everyone was waiting for the Fed to get back to more normal, higher interest rates and it kept getting delayed and delayed with various excuses.  It was excruciatingly slow how they tapered QE, how they stayed at ZIRP, how worried people were about rates getting too high in 2018 when Powell went from 2.25 to 2.50% on Fed funds.  Looking back, investors were out of their minds, thinking 2.5% Fed funds would crush the economy.  

You still hear the voices on CNBC, Twitter, who say that the Fed doesn't need to raise rates, even with sticky inflation.  That is based on the distorted views coming from over a decade of ZIRP and low interest rates.  Many people still view 4% Fed funds rates as being restrictive.  Its not restrictive when the US government runs 6% deficits during an economic expansion and an AI investment boom.   In a recession, those 6% deficits easily double to 12%+ deficits.  Probably even higher as politicians pump out monster stimmy and pork packages during a downturn.  

Fiscal dominance makes high interest rates less effective in slowing down the economy, due to the sheer size of the national debt, and the amount the Treasury funds the deficit using T-bills.  Higher Fed funds rates quickly result in higher interest payments to T-bill buyers, which is a kind of fiscal stimulus on its own.  

The current 6% deficits are papered over with Treasury issuance running at over $2 trillion per year.  There is a supply/demand mismatch.  Without the Fed doing QE, you are left with price sensitive buyers who only buy if the yields are high enough.  Foreign buyers who have to recycle US dollars from their trade surplus would rather buy gold (China) or US equities (Europe) than US Treasury paper.  The government has clearly shown that it doesn't care about deficits.  Most voters don't care either.  They want lower taxes and all the benefits they get from the government.  The government is addicted to tax cuts and spending increases for defense, Social Security, and Medicare, because that's what's popular.  The US population is aging.  There is no way old voters are going to vote for anyone that wants to cut SS and Medicare. 

Inflation is the easiest political choice, because politicians can keep handing out feel good stimmies and tax cuts and blame others for the inflation that comes afterwards.  This reinforces the bond bear market, as high inflation and high interest rates aren't enough to change political behavior.   The only permanent break from this vicious cycle of high inflation and higher bond yields is political austerity.  There are absolutely no signs of that happening.

During this secular bond bear market, there will be cyclical up moves in bonds.  Just as there were cyclical down moves in bonds during the 40 year bond bull market from 1980 to 2020, there will be cyclical up moves in bonds during this bear market.   Its going to need a trigger.  The most obvious one is not the end of the Iran War.  Its the end of the AI investment boom.  The AI bust cycle is the only thing that will stop this bond bear market.  

You will need a bear market in SPX to get a cyclical down move in bond yields.  And most of that down move in yields will happen in the front end of the curve, with the Fed cutting rates, but because deficits will get bigger, long end yields will fall much less.  While the crowd has been conditioned for equities to go higher when bonds go higher, it will be return of the inverse correlation that you saw for much of the dotcom era and post GFC.  In order to get bonds higher, stocks need to go lower.  Its ultimately the stock market that will determine the path of financial markets, not the bond market.  

Retail aggressively buying TLT lately. 

Global growth leading indicators are showing a slowdown for the next several months.  

BofA clients were big sellers for the week ending Sept. 25.  It is an unwind of the heavy buying they did earlier in September. 

GS Prime book leverage for L/S hedge funds shows net exposure at the 2th percentile over the last 5 years.  

Foreign investors were big buyers of US equities in the 2nd quarter.  

AI continues to drive the NDX outperformance over SPX.  It makes me wary of aggressively shorting here.  Still want to take advantage of any rallies to the top of the range to short both NDX and SPX, but probably need another 50-70 points higher in SPX to get a good risk/reward.  Perhaps a dead cat bounce in bonds could provide the premium entry point for equity shorts.  Probably just as good if not better to short long term Treasuries on a bounce.  It just doesn't feel like a bottom for bonds with the lack of fear, poor price action, and seasonal factors.  

While all the talk is about the bond market lately, the effect that bonds have on equities is overrated.  When oil prices go down and bonds bounce on news, it can be used as a good entry point for equity shorts.  But given the lackluster price action and NDX strength, I would only want to put on a small to medium sized short if an opportunity comes up.  Its probably better to save most of your bullets for 2027, when a much more favorable backdrop for short selling comes, as the AI boom slowly turns to a bust.  Until then, don't get buried shorting too early.  As for going long, its too late in the bull market to buy anything but a pullback where fear is palpable.  Haven't seen that since late March.