FINANCIAL ICEBERG

Always consider hidden risks

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MARKET INSIGHT

Is the Bond Bubble will Finally Burst ?

( From CNN Money, Business Insider, Reuters, Seeking Alpha, Market Realist, Broken Markets, FRED, US News )



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At the beginning of each year, the same question arise within the bond managers and the same behavior appear within the financial community especially since the financial crisis began...

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Are we in a bond bubble : yes is the answer

Is the bubble will burst soon : no is the answer

Should we play​​​ the bond market on a cautious note : yes is the answer

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We will try to pinpoint important reasons why we think we can see the bond market behave ok within the next few months.​

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After three decades of declines, interest rates are near rock bottom, and many Wall Street experts think the bond bubble may be about to burst.



In fact, nearly 40% of the 32 investment strategists and money managers surveyed by CNNMoney think that interest rates will begin to rise in 2013, and another 30% say the shift will begin in 2014.

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"Like it's been in the case of Japan, low interest rates can go on much longer than expected, but right now it seems that all the stars are aligned for interest rates to rise," said Jeff Weniger, senior investment analyst at BMO Private Bank. "But ultimately, whether it happens in 2013, 2014 or 2015 doesn't matter too much. What matters is that you're not invested in bonds when they do rise."



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DON'T FIGHT THE CENTRAL BANK



Bond veteran Dan Fuss at Loomis Sayles though thinks bonds are still the place to be, at least for another two years.



"I wouldn't call (this market) a bubble, I'd call it a very strong market," Fuss told the summit in New York but said there was evidence of "a spread bubble", where both yield spreads and underlying U.S. yields have collapsed.



"Put the two of them together and we have a valuation problem - big time," Fuss said.



In emerging sovereign debt for instance, the asset class of choice of many fund managers at the summit, yield spreads have contracted 120 basis points since the start of 2012.



At a time when central banks are pumping liquidity on an unprecedented scale, few will dare to dismiss the bond theme altogether. The United States has just started a $40 billion-a-month money printing plan, giving another boost to Treasuries.



William de Vijlder, CIO of BNP Paribas Investment Partners, thinks there is no imminent risk of the trade going sour.



"If you were to be mispriced, this would only pop up when central banks start to tighten policy," he said.



And that will not happen in the coming year. Many also note that bond bubble fears in Japan 15 years ago were exaggerated.



U.S. 10-year yields at 1.9 percent may look overdone, but Japanese yields were at those levels in 1997, down from 8 percent less than a decade earlier. They are now at 0.7 percent.



"No one in the capital market is brave enough to bet against central banks," Utermann said.



"I would not do that at the moment."

Japan Government Bond 10Y

1995-2013​

2) FED QE Purchases :

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Today the members of the Federal Open Market Committee agreed to undertake what many are calling QE4—a fourth round of asset purchases done in the hopes of stimulating the economy. The committee has agreed to buy $45 billion in longer-term Treasury securities each month, on top of the $40 billion in mortgage-backed securities it is already purchasing under QE3, announced in September. The new program comes as a replacement for Operation Twist, in which the Fed exchanges $45 billion in short-term bonds for longer-term bonds each month. That program ends this month.



So since a year ago, US Treasuries holdings increased by 120 billions and Mortage-backed by 240 billions...( See graphs below )​​

And they plan for now a total of 85 billions $ a month til the unemployment rate reach 6.5%...​

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3) Foreign Central Banks Buying :



Usually, Foreign Central Banks are very discrete about their financial operations but we can have a rough estimate of their net transactions by looking at the ​​Securities Held in Custody for Foreign Official and Intl Accounts ( as shown in the graph below ).

Since a year ago, those holdings increased by a stagering 300 billions $.​

And there is no reason why they should stop buying in that world currency war because the US Dollar is on the cheap side historically as shown by the graph below...

4) US Commercial Banks Excess Cash :



US Commercial Banks invest their excess cash in US fixed income securities​​. Since last year, they bought 100 billions $ of securities as shown by the graph below...

5) No inflation yet in sight :



​​Because of the slow recovery and ample capacity production in the world, inflation remain low in the develaging process as shoen below by the US Consumer Prices Index and the University of Michigan Inflation Expectation Index...

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6) Japanese Style Deleveraging Process Takes Time :

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Low levels of economic growth and high levels of debt are creating significant consolidation in global bond markets. Japan, which went through a similar low growth, low rate environment, may offer a roadmap for bond investors. The late 1990s and early 2000s, for example, turned out to be very supportive for both Japanese and western bond markets. Faced with what is likely to be a long deleveraging cycle and the current eurozone debt crisis, investors will find in today’s bond markets a painful process that only time will bring to higher rates, eventually...



The graph below show how long the yield on Japanese bonds had stayed low for a very long period​​. Even if an accident may happen like in June 2003 : the 2002-2003 episode may be instructive. Between late 2002 and early 2003 a “bubble” developed in the JGB market. By May of 2003 the 10-year Japanese government bond (JGB) yields plummeted to an all-time low of 0.43%. This incident coincided with a massive “flight to safety” associated with a crash of the Nikkei-225 index to a 20-year low.

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What is instructive about this incident is that on June of 2003, Bank of Japan Chief Toshihiko Fukui moved to burst the JGB bubble. In a series of statements, he made it sufficiently clear that the BoJ would take steps to insure that JGB yields would rise. Three months later, the 10Y JGB yield had more than tripled, rising above 1.50%. The Nikkei-225 also rose from a low of 7,650 to above 10,000, based on the threat of BoJ engineered inflation.

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In a fiat monetary system, there are severe limits to how low government officials will allow inflationary expectations to go. There is therefore an associated limit on how low long-term bond yields can go. But as long as FED officials keep the inflation exectations at bay, no perceived risk here...

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7) Aging Population :



​​ Demography is key to understanding why such times with high yields may never return. In the last four decades of the 20th century, there was an unprecedented rise in life expectancy and a drop in birth rates. This left the industrialised world with a demographic profile very different from the 1950s. Growing evidence suggests that ageing populations will weigh on economic growth and asset values for years, if not decades. ( See graph below )



Populations in most major industrialised nations are ageing rapidly, which means the proportion of those saving for retirement – generally investing in equities – is diminishing. As the baby boom generation – people born in the years immediately after the second world war – grows older, its investment preferences tend to favour safer assets such as bonds. This, added to a regulatory drive to push banks and insurers into “safer” assets is driving yields on those assets lower, research suggests.



8) Pension Funds Desperatly looking for yields :



​​ As corporate pension plans and other investors keep piling into longer-dated corporate bonds, seeking better-than-Treasury yields to match their future liabilities, those corporate bond yields keep falling. That’s setting up a longer-term problem for pension plans.



Pension-plan demand for investment-grade corporate debt could be between $100 billion and $150 billion over “each of the next several years,” according to Michael Moran, a pension strategist at Goldman Sachs Asset Management. “We think it could actually place a little bit of a ceiling on interest rates at the long end of the yield curve.”



Investor demand is already so strong that yields on corporate debt have fallen to historic lows.



Corporate pension plans could stoke demand further as they adopt “liability driven investment” strategies. Those strategies call for more closely aligning the average maturity of a plan’s assets with its liabilities — or how long it expects to make payouts to plan participants. Doing so leads companies to invest less in equities and more in 10-year and 30-year bonds.



So all in all, if doens t mean that the bond market can t trade in a choppy manner, but that the huge backup in yields should be short live because of the factors mentioned above...

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"We've had a 32-year bull market in bonds and I think it's over," said Harry Clark, chairman & CEO of Clark Capital Management Group in Philadelphia. He thinks that over a period of several years, the 10-year rate will move closer to its historical average of about 4.5%.



But Clark is quick to note that the challenge is getting the timing right. There are many reasons to think that rates should head a lot higher than where they are now. However, with the Fed acting as a buyer of last resort, it seems unreasonable to expect a bond bloodbath like we had in 1994.



Clark said over the next 12 months, he doubts that the 10-year yield will move higher than 2.4%. And he said rates could possibly move back toward historical lows of near 1.4%. So a kind a wide range trade for 2013...





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9) US Treasury supply will shrink because of the fiscal Cliff :

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According to SG : at the very minimum fiscal policy will shave 0.8% from GDP next year. This is a result of payroll tax hikes and spending caps which have little chance of being reversed. Our central scenario also assumes that the planned spending cuts will not be reversed and that Bush tax cuts will expire for the wealthy. Combined, these measures would reduce the deficit – and thus Treasury issuance – by more than $300bn in FY’2013. We project net new Treasury supply of $821bln in the fiscal year that began on October 1, down from $1,126bn in FY’2012.



Net Treasury supply available to investors could be further reduced by Fed buying. We expect that the Fed will continue to buy long-dated Treasury securities beyond the Maturity Extension Program which expires at the end of the year. Maintaining the $45bn/month buying pace through 2013 would reduce net supply of Treasury paper by a further $540bn. Given our fiscal assumptions, this would leave only $281bn of new Treasury debt available to investors. This constitutes a 75% drop from Fed-adjusted supply in FY’2012. In contrast, if the entire cliff were to be avoided, the Fed would likely end its flow-based QE earlier than we expect and the net supply would remain close to $1tn. However, this is not a likely scenario in our view.







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