JGB rates starting to matter to the rest of the world

Japanese 10-year JGB yields are now 2.34, the highest this century. An end to loose monetary policy, continued loose fiscal policy with the expectation of a tax cut, the "Takaichi Trade", and persistent inflation that is currently at 2.9% means that there is a strong reason to see yields move even higher. The rising JGB rate is having an impact worldwide as money starts to flow back to Japan. Now, it is hard to say this is a complete reversal when real rates are still negative, but the global financial landscape is changing, putting pressure on Treasuries and rates in other countries.

What if we have clarity on Treasury rate direction?

 

We have been strong believers in using volatility, whether the VIX or the MOVE index, as a strong indicator of fear and uncertainty. This is a nonlinear relationship. An increase does not necessarily mean a decline in prices, but once volatility exceeds a threshold, there will be a strong price reaction. Now, we can look at the decline in the MOVE index and infer that the term premium should decline. Since September 2004, short rates have declined by 175 bps, yet long-term yields have increased. This is not what should be expected. Lower volatility should reduce risk and lower yields. This is not happening. 

So what is the reason for the higher, longer-term yields? Well, if volatility measures uncertainty, perhaps there is no uncertainty at all, and bond investors are clear. Bond buyers believe there is greater risk in holding Treasuries, that inflation is rising, and that the safety of dollar Treasuries does not exist. In that case, volatility can be lower, and rates trend higher. Lower volatility and lower uncertainty do not mean clarity is good. 

A link between policy uncertainty and gold

 

"A bet on gold is really a bet that the people in charge don't know what they're doing."

- Matt O'Brien, 2015

'The monetary order is breaking down,' - Ray Dalio

Gold prices have reached uncharted territory amid US policy uncertainty and trade tensions. You could look at headlines and make some connections, but more importantly, we can examine objective measures of uncertainty as indicators of a change in the monetary order.

The trade policy uncertainty index has fallen from high levels, but remains at extreme levels. The global economic uncertainty is also high and at extremes. 

If the monetary order and policy framework is breaking down, there will be a search for safety. However, if the safety of holding dollars and Treasuries is no longer present, we will see a search for alternatives, and right now that is in precious metals. 

Gold allocations will rise, and even a small increase across many portfolios will create demand that current mining production cannot meet. This is fueled by increased demand from central banks. 

Combining volatility (fear indexes) - a strong indicator

 

We know that many investors use the VIX index as a fear gauge or just a measure of market risk. We also know that the same investors use the MOVE index to measure volatility and fear in the bond market. Some researchers decided to look at the divergence between these two indices as perhaps a stronger signal; see "Divergence of Fear Gauges and Stock Market Returns". The authors find that the divergence of fear indexes (regressing MOVE on VIX and using the residuals and the MOVE/VIX ratio) is a negative predictor of future equity market returns. This predictor does well for both in-sample and out-of-sample tests. 

Looking at the difference between MOVE and VIX indexes is a simple measure that can be followed by almost any investor. Simplcity may make this indicator obsolete if "everyone" is using it, but in the near term, we think this is a good, simple signal tool that I have been using for some time in different forms.