Passive investing is distorting the bond market.

Hidden Forces Interview Explains How Passive Investing Has Destroyed the Functioning of the Bond Market

 

On the Hidden Forces Podcast, host Demetri Kofinas interviews Andy Constan, principal of macro research firm Damped Spring, and Mike Green of Simplify Asset Management, a well-known expert on how passive investing is distorting financial markets.

Here are some of the highlights of their interview which you can listen to here:

Mike Green: Believes the Fed has already overtightened. However, monetary policy works with long and variable lags, so it will take time to see the effects.

Short-term floating rate borrowing via commercial paper has been reduced after Great Financial Crisis of 2008, so the economy’s sensitivity to rising rates is slow to develop. This makes the current period similar to 2004-2008. We’re seeing the same debates among financial market participants as previous cycles. Do rate hikes matter? They always do.

Stimulus is what makes the difference this cycle. ERC (Employee Retention Credit) fraud, the fall in oil prices both created additional buying power for consumers.

A big factor in the bond sell-off is the rigidity of portfolio allocations that are prominent in passive investing strategies.

Low rates of labor force growth makes it difficult for unemployment to pick up. Therefore we have an extended cycle.

Have we tightened to the point that we experience a hard stop as opposed to a slowing of the economy? He believes we have.

Andy Constan: Has held the view that the Fed will hold rates higher for longer.

A year and a quarter ago  he called the QT (quantitative tightening) effect by having the Fed roll securities off its balance sheet.

He believes the Fed has focused on the wrong thing in hiking rates. Thinks they should instead be focused on contracting balance sheet more than they have.

MBS (mortgage-backed securities) roll-off on the Fed balance sheet has been anemic at best. The Fed’s portfolio has been heavy on duration.

He has been calling for more QT since January.

The debt ceiling crisis created a pause in Treasury issuance. This supported bond prices from November 2022 to July 2023.

In the aftermath, there was a lot more Treasury issuance which hit prices and bond prices have declined sharply.

He thinks QT transmission has further to run.

We are now starting to see real credit tightening in the economy due to higher long bond rates. He believes the Fed raising interest rates did not have an effect since very few people borrow in short term interest rates, the longer term interest rates matter much more to economy activity.

The yield curve inversion has to be followed by a bear steepening

Mike Green: Thinks both he and Andy both got this year somewhat wrong, mostly due to bond market supply.

The rigidity of demand in response to supply is the issue.

Junk bond issuance has slowed to a crawl because companies cannot refinance. This has kept spreads from blowing out.

The refinancing wall is moving rapidly toward us in a very meaningful way.

The maturity of the high yield index is below 5 years for the first time in history. This is telling us that there is a large wall of companies that need to refinance in the next 2 years but they can’t because the interest rates are uneconomic for them. So they are hoping Fed will lower rates.

Mike thinks if rates stay high, things could become much more disorderly in the markets.

Markets are limited to adjust to increases in Treasury supply when demand is fixed.

The demand side is very slow to change: people need to adjust 401(k) allocations, investment committees need to discuss and agree on allocating more to bonds.

The more these institutions run a fixed allocation strategy, the more prices are determined by supply. Investors do not have has much discretion to shift towards buying bonds as they did in the past.

In a very odd way the Treasury has more control over the curve than the Fed because they dictate Treasury issuance.

No one is asking why am I holding equities? I should be getting out and buying bonds, despite fact that many institutions could meet their return objectives with the way rates are today.

Andy Constan: Janet Yellen choosing to issue long-term bonds enhances the transmission mechanism. The lever got taken out of her hand with debt ceiling.

By December the Treasury will have issued 22% of all government debt held by public in the form of Treasury bills. This is extremely high historically. So, Yellen needs to issue more long-term bonds. The budget deficit is so large. $580 billon projected quarterly issuance to fund the deficit.

Andy’s projects that $480 billion of duration (long-term bonds) must be issued given the split between bills and bonds.

Markets roar when the TGA (Treasury General Account, essentially the government’s checking account) is spent down and not replenished by issuing bonds, like happened this year during the debt ceiling crisis.

Mike Green: The most important thing from Andy’s discussion is that the debate over growth and inflation did not matter. It’s more the technicals of the market, supply and demand money flows. People think we’ve entered into a secular inflation period or that the economy is booming, which is causing bond yields to rise. However, this is not relevant to the bond price discussion now and is also not true. The economy has decelerated and inflation has retreated from its peak. The most interesting question is is what are the unintended consequences of the Fed’s actions?

There is a ton of supply coming into the duration market. It’s an 8 to 9 vol instrument while front end of the curve has no vol. When you deeply invert the curve, you make it less attractive to finance the bonds. This lowers demand.

Perversely, by hiking the short end and not working QT aggressively on the long end, we have not seen the curve steepen as you would hope to see an increased cost of capital for longer-term financing that would slow manufacturing construction, housing etc.

We’ve built up a dam that can suddenly break at some point with higher costs of financing.

The Treasury is the dumbest participant in the market and is driving the actual bus [editor’s note: we constantly ask this question in relation to the stock market].

The Treasury could be locking in extremely poor rates of financing now.

You can see the change in inflation expectations over the last year in the TIPS market (Treasury inflation-protected securities).  This shows the cost of obtaining real dollars in the future.

18 months ago, it cost about $1,200 to preserve $1,000 worth of purchasing power 30 years in the future. Today it costs $520. So it’s gotten dramatically cheaper because inflation expectations have declined and interest rates have risen. This should change how almost every asset is valued if the market is rational and pricing things on discounted cash flow, but unfortunately this is not happening [due to the dominance of passive investing strategies, markets efficiency has been destroyed].

Andy Constan: Thinks market will adjust, it just takes time.

$1.6 trillion out of $30 trillion of government debt would be refinanced at higher rate – not a lot. Treasury is incentivized to kill inflation so Fed can cut and then can finance the Federal debt at lower rates.

What are the long-term consequences to this rapid long-term rate rise?

Andy Constan: I think the Fed approached it correctly, it was just out of their hands, impacted by the debt ceiling issuance pause.

Usually when interest rates rise, something breaks in credit. Silicon Valley Bank was too small, so there was a lack of contagion. Bigger banks benefited because they got deposits.

Mike Green: Agreed, the money from the failed banks flowed into JP Morgan, not out. Silicon Valley Bank (SVB) did not do a terrible job managing duration relative to other banks. High bond yields have caused large losses in other banks. SVB was really exposed to a traditional bank run with a concentrated deposit base: Silicon Valley startups.

First Republic Bank – had high quality debt and also experienced a deposit run in a similar way.

Andy Constan: The main point is there was no contagion. So if nothing breaks, what creates a slowing economy? Demand destruction. Happens with 2 drivers: job losses – haven’t seen these yet. Then asset price declines – these have a wealth effect impact. Just recently the wealth effect has reversed with market decline.

In my model, this is Act 4 – bonds become cheaper, we get demand destruction on earnings expectations. Companies will fire people instead of hoarding workers. Likely in service-oriented companies that will only fire workers once they see demand destruction. I think we are early in that process.

How important is the lock-in rate of mortgages, so many people have low rates? Why is it that equity prices adjust lower when bond yields go up?

Mike Green: A dollar in future has to be equal to a dollar today when discounted at the appropriate rate, whether it comes from equities or bonds. Equities are uncertain, so they require higher discount rates. None of that really matters if investors are not able to pick stocks versus bonds.

Target date funds that are 75/25 bonds to equities, nowhere in their models do they consider prices of bonds and equities. Assumes there is no ability to have knowledge. When the Shiller P/E was developed, originally people were very excited because it gave us a historic model for equity returns.

That model failed due to the systematic allocation models and passive. That can’t be explained by prior history. Led to nihilism in financial markets. No mechanism for target date funds to change allocations. It is untested to get large institutions to change their models. Probably saw the reverse of that when many firms remained allocated to bonds when they had minuscule yields.

What parts of the economy are most exposed to refinancing costs?

Andy Constan: Equity “jaws” are at all time high. The market is not reacting to higher interest rates. Analyst consensus for earnings growth over the next 2 years is very high.

High nominal GDP growth is fueling high earnings expectations. He does not think companies will meet these high expectations and will disappoint investors.

Mike Green: Home sales continually face refinancing, so they are rate sensitive. Other areas are the auto sector: sales and leasing activity are getting hammered by higher rates. Also, commercial real estate were financing is relatively short-dated.

The effects of the interest rates have a long lag but all this is a slow-moving trainwreck.

 

 

 

 

 

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