Yields and Leverage

There's a room where the light won't find you
Holding hands while 
The walls come tumbling down
What they do, I'll be right behind you
--Tears for Fears

Ten year Treasury yields are once again breaking lower. Now under 1.7%, T-note yields seem intent on testing all time lows of about 1.4% reached in summer of 2012.

Treasuries aren't the only ones. Sovereign bond yields in countries deemed as safe havens, such as Germany, are all marking lows.

This is occurring to the dismay of many. "How can people pour into bonds here?" "How can bonds be bid in a world where printing presses spit money like confetti?" "Don't people realize that they are buying yield-free risk here?"

All valid points, but they reflect an oversimplified, linear in a world wrought with lags and complex non-linearities.

In NIRP and ZIRP worlds, for example, people will buy low yields to squeeze out return. They will be particularly prone to reach for yield as long as they believe policymakers have their backs. Thus, yield-suppression actions of policymakers along should make the low bond yield phenomenon unsurprising.

One also needs to be aware of what is likely to happen when markets transition from high to low risk appetites--particularly when those markets are leveraged. When risk appetite is high, borrowers will invest more of their borrowed proceeds into risky asset classes like stocks. They will also buy bonds to the extent that the investors perceive that they can make money on the spread between borrowing cost and coupon yield on purchased bonds.

Investors will be even more enamored to buy bonds at low spreads if they a) can borrow lots of funds to put to work on those spreads, and b) have confidence that policymakers won't suddenly raise borrowing rates--which would effectively call in their loans at a potential loss.

This, of course, is precisely what we've seen: leveraged trades in stock AND bonds, which has pushed prices of both higher. As long as a) and b) remain in effect, then risk preference seems the key variable. As long as carry traders maintain high risk appetite, then we should see bonds continue to be bid, and yields continue to fall.

However, bond are likely to be bid and yields are likely to continue to fall EVEN when risk appetites begin to decline. This is because carry traders probably won't immediately take all risk off the table when they begin to lose their risk appetite. Stated differently, traders are unlikely to deleverage right away. Instead, they WILL ROTATE OUT OF HIGH RISK INTO LOW RISK. Out of stocks and into bonds. Out of corporates and into Treasuries.

All the while, bonds get bid and yield falls.

This continues until risk appetite is so low (or a) and b) leave the room) that investors no longer want to carry any leverage. When that occurs, traders sell their bonds and deleverage, which causes yields to increase--perhaps quickly.

Note that when that deleveraging occurs, then we have deflation (money and credit supply contracting as loans are extinguished thru payback or default).

Note also the effect that seems opposed to conventional wisdom: bond yields INCREASE during deflation--not during inflation--.

This would all be different if the backdrop was not one of debt and unnatural leverage. However, as long as the world is unnaturally leveraged, the lower sovereign yield phenomenon is not a sign that investors have confidence in particular economies or economic policies or even low inflation. It is a sign of changing risk preferences and high inflation.  Historically low yields signal that risk appetites are closer to the point where carry traders are ready to jump ship and deleverage.

Given the huge amount of leverage in the system currently, this should give the thinking person cause for pause.

position in SPX