The new bond world - melt down

The fixed income world has moved very far in 2015. In the first quarter, the key issues were deflation, falling oil prices, action by the Fed, a new QE program by the ECB, and talk of secular stagnation to name just a few major themes. Fixed income was still considered a safe asset even at negative yield levels. That has all changed.

There is no one single event that is driving bond markets to higher yields. In fact, analysts have not found a smoking gun for causation. This has just added to the uncertainty. The market would like to point to a single cause and it does not exist. 

I will call it the "revenge of the bond risk premium". Risk premiums in bond markets have always been hard to measure but it has been clear that they has fallen significantly and in some cases measured to be negative. Whether measured by excess returns, by the residual after inflation expectations and growth, or devations from the average of short rates, bond premiums have hit extremely low levels. These levels cannot be sustained and are subject to changes in uncertainty and volatility. 

It does not take much for bond holders to sell assets when the yield cushion is close to zero or negative. All you need is a change in mass expectations and some momentum trading. If we go back to the original list at the beginning of the year mentioned in the first paragraph most would agree there is more uncertainty on all of these issues. 

• Deflation - headline levels are rising and deflation fears may have bottomed;
• Oil prices - moving higher and may be ready to find a trading range;
• Fed action - clearly uncertain albeit any account has been pushed into the future;
• ECB QE - has been started but questions of potentials success abound;
• GREXIT - this drama will not go away;
• secular stagnation - the first quarter slowdown may be more than temporary;
• geopolitical risks - leadership is in short supply;
• fiscal policy - don't know what that is in an age of austerity; 
• EM exit - same old story, dollar goes up and EM goes down 
• currency wars - still ongoing;
• China - the "robust" economy that the government needs to continue to support.

Forget the cause story and accept the world of deleverage and no safe asset.