As the December Fed policy meeting creeps ever-closer, some of the largest bond traders are bracing for a storm. That's not to say that there will be an upheaval in the bond market, but "better safe than sorry" appears to be the mantra, at least in the short term.
The imminent rise in benchmark interest rates will have a follow-on effect in the broader bond market. The only question is how much of an effect, and how volatile will the transition be to higher rates?
Trying to wind down a stimulus program, the likes of which the market has never seen, is uncharted territory. Perhaps there is nowhere the shoals ahead are more treacherous than the bond market. Big fixed-income fund managers are moving out of corporate debt, and into long-term Treasury notes. Others are taking a wait and see approach, and moving into cash until the immediate fallout of next week's interest rate by the Federal Reserve can be assessed.
"You Have No Power Here!"
One area of concern is the $2.5 trillion in excess cash that the Too Big To Fail banks got from the Fed. That is money that is just sitting there. These unprecedented cash reserves means that the Wall St. banks have no need to use the Fed's overnight lending mechanism, known as Fed Funds. This has traditionally been the way the Fed influences the interest rates in the broader market.
There's a Reason They're Called "Junk"
The Fed's quantitative easing program and "zero interest rate policy" (ZIRP) destroyed the yield on traditional safe haven bonds. It also opened up easy credit to even the riskiest of ventures. Investors, desperate for yield, clamored for the resulting "high yield" corporate bonds. Even normally conservative investors such as pension funds were forced into the high-yield market in order to meet disbursement requirements.
As long as the Fed was "printing money" and keeping Fed Funds rates near zero, it was easy for the companies behind these low-rated bonds to roll their debt over into new issuance. But when the market started pricing in a Fed rate hike, there were suddenly no buyers for all the sellers who wanted out. This lack of buyers has pushed yields much higher, as sellers slash prices in order to bail out of their positions.
The market is relearning that "high yield comes from high risk," and retail investors aren't liking it. Redemptions in junk bond funds are at records, and at least one prominent junk bond fund is refusing to let investors cash out.
Robots + Oil Crash = Doom?
The Financial Industry Regulatory Agency (Finra) warns that increasing defaults in the energy and mining sectors have a high probability to create market turmoil. This situation may be worsened by computer High Frequency Trading (HFT) programs, which will flood the market with hundreds of fake orders and then withdraw them within milliseconds after "spoofing" the price of the bond to move in the direction wanted. These programs put human bond traders at a disadvantage.
Any Bonds Today?
Corporate debt isn't the only bonds experiencing a liquidity trap. Bond traders in the US Treasuries market are also experiencing challenges matching buyers with sellers. The large investment banks that usually act as middlemen in this market have been reducing their balance sheets to meet new Federal guidelines meant to avert another financial crisis.
These light volumes and liquidity issues make bond prices swing further and faster than economic fundamentals would otherwise dictate. This will present yet another headache for the Federal Reserve, when it begins unwinding its massive balance sheet full of bonds that it purchased from the big banks during its quantitative easing programs.
Going Long on Treasuries
Bond traders are "going long" on US debt, as the prevailing view is that the Fed will take a slow approach in the pace of normalizing interest rates. This means that the 10-year and 30-year Treasuries will not affected as much as shorter-term T-bills. Short-term Treasuries are seeing tepid interest ahead of the first rate hike. The exception Treasury bills with a maturity of 90 days or less, which are more liquid and count as a "cash equivalent" in accounting.
As the economy begins adjusting to a normalization of monetary policy, the bond market should return to a pre-crisis "normal" level.
If nothing goes wrong, that is...
The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.