Earlier this month, SocGen’s Albert Edwards restrained himself from taking a victory lap amid the epic plunge in global bond yields, which, on many fronts, validates his long-standing “Ice Age” thesis.
Fast forward a couple of weeks, and the bond rally hit escape velocity, with 10-year yields in Germany diving to near -0.70%, while benchmark yields stateside fell below 1.50% and 30-year yields pushed below 2% for the first time, in an inexorable bout of bull flattening that culminated in the inversion of the 2s10s last week.
As a reminder, the rally in the US can be attributed in part to positioning and hedging in a low liquidity environment.
But the catalysts (e.g., convexity hedging) which served as gasoline on the fire don’t obviate the need to concern yourself with the bevy of macro factors arguing for lower yields. The growth outlook is tenuous, at best. Inflation expectations have plunged. Commodities are grappling with the prospect of demand destruction tied to a global slowdown. And central banks are pot-committed to more easing, while the market is openly questioning their capacity to reflate. It’s a perfect storm for a bond rally.
For Edwards, there is nothing surprising about any of this.
“My own view is that this government bond rally is not a bubble but an appropriate reaction to the market discounting the next recession hitting the global economy from all overleveraged corners of the world (including China), with close to zero core inflation and precious few working tools left at policymakers’ disposal”, Albert writes, in a Thursday note.
Unsurprisingly, Edwards isn’t buying the idea that the yield curve isn’t a reliable predictor of a US recession. In his Thursday note, he reiterates his contention that the New York Fed recession predictor (using the shape of the US yield curve) has to be recalibrated if you want an accurate read on probabilities.
“The problem is that Paul Volcker crushed the economy with sky high Fed Funds rates in the early 1980s and that has heavily distorted this otherwise very useful NY Fed series”, Edwards contends. If you recalibrate it to sit near 100% during the last two downturns, you can engineer “a 75% chance of recession”.
After observing what he says is a worrying decline in hours worked in the US, Edwards turns to collapsing bond yields.
“Most investors are stunned by the plunge in 10y bund yields ever closer to minus 1%, also our target for the US 10-year [and] for many this has turned into a bubble of epic proportions that will surely soon burst. But will it?”, Albert asks.
He thinks perhaps not. Indeed, Edwards asks investors to consider whether “shorting western government bonds [is] the equivalent of the fabled widow-maker trade in which investors consistently lost money shorting Japanese bond yields despite yields seeming ridiculously low in the face of explosive government debt supply”.
Looking at the charts, Albert says bunds don’t look like a bubble. “[The decline in] German 10-year yields (monthly plot) to close to minus 0.7% does not seem so extraordinary – merely the continuation of a downtrend within very clearly defined upper and lower bounds”, he writes, before observing that “the US 10-year has mostly occupied the top half of its wide downtrend band since 2013, fairly unsurprising given the stronger US economy together with Fed rate hikes”.
Getting back to fundamentals, Edwards cites a model that fits US yields with trend growth and inflation and notes that “given the demographic situation, inflation is likely to remain subdued”. And speaking of inflation, he asks you to consider the following two visuals:
“Does the left-hand chart suggest implied 10-year inflation expectations look too low? Not to me”, he says, adding that “the same goes for real yields on the right”.
Albert also throws in a “classic Ice Age chart” showing that “the last few cycles have seen a sequence of lower lows and highs for nominal quantities along with bond yield and Fed Funds”. Albert employs a 4-year moving average, and then extrapolates to show where he thinks we “may be heading in the next downturn and rebound”.
That, Edwards says, “is why this is not a bond bubble”.
So what is it if it’s not a bubble?
Well, “it is the next phase of The Ice Age”, Albert declares. “And it is here”.
Read the counterpoint from Kevin Muir: Macro Tourist Likens Bond Bubble To Dot-Com, Real Estate Blowups In Sweeping New Critique