Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 75% of retail investor accounts lose money when spread betting and/or trading CFDs with this provider. You should consider whether you understand how spread bets and CFDs work and whether you can afford to take the high risk of losing your money

75% of retail investor accounts lose money when spread betting and/or trading CFDs with this provider. You should consider whether you can afford to take the high risk of losing your money.

Columnists

Bond markets set for huge rally in 2019, by Raoul Pal

Last year, the markets were heavily influenced by all things macro, from the growth and crash of the S&P 500 to China’s stuttering stocks. The dollar, interest rates and oil prices all played major roles, catching out many investors blindsided by the bigger picture playing out. 

The defining feature of 2018 was the collapse of emerging markets. The main feature of 2019 will likely be the contagion into the developed markets – most likely in corporate credit, at least to begin with. Corporate debt has risen sharply during this cycle and has attracted $4tn in inflows. 

$4tn

Inflows to corporate debt

The problem with the credit markets is that the Fed has gone too far, too fast. In addition to the shrinkage of the Fed balance sheet, interest rates over the last two years have risen at their fastest pace in history. It’s not the level of rates that matter but the rate of change, and it really matters when the debt burden is enormous and people have refinanced their debts at lower levels. The rate of change is starting to bite – and hard. 

 

GMI Hard Data Index

I have developed an indicator which best captures the business cycle – the GMI Hard Data Index – and it is highly correlated to GDP (fig 1). When I put it against the rate of change of Libor (fig 2), we get an alarming insight into the future of where the GMI Index (and therefore GDP) is going.

The true tightness of money is showing up all across the global economy, be it in EU banks or global car sales, in global home prices or emerging market currencies. However, the market is only just starting to listen, as the drumbeat of impending recession gets ever louder.

Over the course of the year, we should see a serious downturn in the business cycle, when global GDP drops sharply and market weaknesses start to be discovered. If the hard data falls then world growth will plummet, too. 

 

Market volatility

What does this mean for the markets? It means volatility and reversal of the trends of the last five years. 

Most asset prices are correlated to the business cycle. So if the business cycle turns negative, so will the return on assets. This becomes clear when you look at the GMI Hard Data Index and the S&P 500 (fig 3). A similar correlation is seen when the index is applied to credit spreads and corporate cash flows that service that debt.

The opportunities may lie in going long on the US dollar as the world scrambles for dollar funding. They may also lie in getting out of all credit exposure or betting on credit markets concerns. Equity markets around the world are likely to suffer. The Russell 2000 is forming 
a head-and-shoulders top and will likely break lower in Q1 2019.

But the biggest opportunity of all may come from betting that the Fed is not only pausing but will be forced to cut rates later in 2019 or early 2020. The bond market has seen rather subdued volatility as investors have placed record short volatility bets on bonds. For me, it’s the largest short volatility position in history. The MOVE Index of bond volatility is flirting with all-time record lows as the volatility sellers suppress action in the bond market.

 

Year of bonds

Market speculators also have record short positions, and the pension and mutual fund industry are massively underweight bonds. The kindling for a huge rally in bonds (fall in yields) is firmly in place. All we need is the catalyst to emerge. 

“The kindling for a huge rally in bonds (fall in yields) is firmly in place. All we need is the catalyst to emerge”

And as the Fed pauses, interest rates tend to fall sharply across the curve, meaning that two-year, five-year, 10-year and 30-year yields all fall. (Note that the Fed never pauses and hikes again. Each “pause” always becomes the end of a rate cycle – the bond markets know it first. This is why yields fall sharply, in anticipation of economic weakness and potential rate cuts).

It will be a tricky, tricky year ahead, but in my opinion, it will be the ‘year of bonds’, above all other things.

Written by

Free ebook

Tricks of the trade: 7 interviews with the world’s top traders

Get it now

Continue reading for FREE

Join the 10,000+ subscribers getting market-moving news every week. Sent three times a week in accordance with our privacy policy.

  • Unsubscribe anytime

Disclaimer

Past performance is not a reliable indicator of future results.

CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.

The material has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Although we are not specifically prevented from dealing before providing this material, we do not seek to take advantage of the material prior to its dissemination.

CMC Markets does not endorse or offer opinion on the trading strategies used by the author. Their trading strategies do not guarantee any return and CMC Markets shall not be held responsible for any loss that you may incur, either directly or indirectly, arising from any investment based on any information contained herein.

Related articles