Bonds Up, Stocks Down – The Sinister Truth Behind March’s “Portfolio Rotation”

A cheesy Western standoff often begins with some variation of, “This town ain’t big enough for the both of us.”

That’s where we are now with stocks and bonds. And we’re approaching the point where the town ain’t big enough for either of them.

The Treasury continues to pound the market with massive amounts of new supply. But Treasuries held their own this month. In fact, they rallied a bit.

Instead, stocks got their turn in the barrel. This illustrates the point I have been making that there’s no longer enough liquidity in the system to support bull moves in both stocks and bonds. If one rallies, the other must be the source of funds for that rally. So in March, stocks were the liquidity sink that supported the rally in bonds.

And don’t be fooled by Thursday’s rallies in both stocks and bonds: neither baseball, life or financial markets move in a straight line. They are full of surprises. But there’s always a broader arc that contains these surprise days. Our job is to identify the direction of that arc. And in this case the forces of that broad arc are pointing down.

Here’s what the “stocks vs. bonds” standoff is telling us about the incipient bear market – and my recommendations for what to do…

Alternating “Liquidation Waves” Intensify – And Lead to A Bear Market

I wrote back in mid January that, “As the Fed pulls money out of the financial system, there’s no longer enough liquidity to support bull moves in both markets simultaneously. I have forecast that here, and I expect that to be the theme of this market for only a little while longer. Within a few months I expect that stocks will also succumb to a growing shortage of cash as the Fed pulls money out of the system and the Treasury pounds the market with immense amounts of new supply.”

I’ve also noted in the past that dealers and speculators seem to have funded their stock speculation by increasing the type of short term borrowing that normally finances their bond purchases. They have instead shifted the cash from those borrowings to stocks. This is borrowing from the future for speculative profit today. It won’t end well, thanks to the gathering forces of increased Treasury supply, Fed draining, and less cash from the Fed’s two biggest cohorts, the BoJ and ECB, who have cut back their QE programs, and threaten to end them later this year.

Again, in January I said, “This first quarter of 2018 should be the turning point. We are facing be the worst liquidity conditions that we have seen since the 2008 collapse and those conditions will only tighten more through the year as the Fed increases its drains from the system and the Treasury pounds the market with gargantuan slugs of new supply.”

Then we got the stock market break in early February. Bonds had been selling off starting from mid December. So what happened to the bond market when stocks crashed in early February?

Nothing. There was no rally in bonds. When dealers and other market participants liquidated stocks in early February, they did not use the cash to buy bonds. In fact after stocks bottomed and began a spirited rally on February 9 the selling in bonds continued. If anything, we saw rotation out of bonds and into stocks. The bond selloff continued until February 21.

The stock rally had twin peaks at the end of February and on March 12. Bonds rallied modestly beginning on February 21. That rally picked up a little steam last week. As stocks were sold off from March 13 to March 28, some of the cash from that liquidation was used to buy bonds, contributing to that bond market rally.

That’s portfolio rotation, folks. And it’s not positive rotation. It’s alternating waves of liquidation.

During Fed QE from 2009 to 2014, the Fed constantly pumped more than enough money into the markets to fuel bull moves in both stocks and bonds. Sometimes they moved in rotational fashion, but often the moves were concurrent. We got used to seeing simultaneous bull markets in both stocks and bonds. That was the Fed’s purpose for QE, and it worked.

I had speculated in early 2009 that this new money printing program had the power to turn the bear market around. Since the program was new, I couldn’t be sure, but when the long term technical indicators turned bullish in April 2009, about a month after the bottom, I became convinced that the Fed had successfully rigged the system to foment a bull market. I reluctantly got on board. The Fed makes the rules, and Rule Number 1 is “Don’t fight the Fed.” I respected that.

When the Fed mostly stopped printing in late 2014, the ECB and BoJ took the handoff and continued massive money printing programs. Lots of that foreign central bank printed cash found its way to Wall Street, because the same banking behemoths trade with the Fed, the ECB, and the BoJ. Ultimately, all financial roads lead to Wall Street. Money printed anywhere can and usually does quickly find its way to the US markets.

But in October 2017, the Fed began to shrink its balance sheet. And that literally pulls money out of the banking system and the markets. The mechanism is circuitous. I won’t describe it again here because we have talked about it in other posts. Today we’re looking at the effect. It was an effect that I expected and forecast, and now it’s happening. It’s not rocket science. If we bother to take the time to connect the dots in view of Rule Number 1, it becomes perfectly clear what is likely to occur.

So there’s no longer sufficient liquidity to support concurrent bull moves. The town isn’t big enough for two gunfighters. And I forecast that initially we’d see rotating waves of liquidation in stocks and bonds.

I expect more of this rotational liquidation in the months ahead. As the Treasury continues to bury the market with supply month in and month out, and the Fed pulls more and more money out of the system, the time will probably come when both stocks and bonds sink together. The town will get so small, the gunslingers will just leave.

Here’s Why The April-May Rally Won’t Stick – And What to Do with Your Money

So I’m sticking to my recommendation to be 60-70% in cash (more or less depending on your circumstances). When I first suggested that back in September, I said that it should be done gradually and systematically, selling a small amount each month as the market rallied, with the goal of reaching that cash level by the end of January. As time went on I said that if you hadn’t gotten there yet, again do so in increments by the end of March.

Then for late arrivers, I wrote that the goal should be to be at that level by May. That’s because the market usually has a rally from around mid-April to late May. The Treasury takes in so much cash on income tax day that it pays down some debt. That puts billions in cash back into the accounts of the dealers and investors who had been holding the paper that was paid off. Those temporary paydowns provide the fuel that usually triggers a rally.

However, this year the paydowns will be smaller than usual. In their infinite wisdom, the Congress and the Administration have massively increased the deficit via the tax cut and the spending deal. These deficits must be covered by selling new debt. Those debt sales will pull massive amounts of cash out of the market month after month. In March alone that totaled a mind bending $271 billion in net new issuance.

Somebody has to pay for that. Under QE, it was the Fed. But that game ended in 2014, and now the Fed is actually stabbing investors in the back by pulling money out of the system just when the Treasury is making these freakishly huge demands on it.

So here’s the thing about those big paydowns that come every year from mid April to mid May. This year those paydowns will only total $16 billion if the TBAC guess is close to the market.

Yes, that should be enough to give the market a respite from the onslaught of Treasury supply. But it’s hardly sufficient to fund a big rally in either stocks or bonds. Remember – in April the Fed starts pulling $30 billion per month out of the banking system and the markets, up from $20 billion now. The short term Treasury paydown won’t make up for that.

So don’t hesitate to continue raising cash. Whereas before I said to sell into rallies, now I’d be reticent to wait for a rally. The next breakdown that takes out the February lows could trigger a dramatic selloff. If that occurs, it would confirm a bear market, and there would be no reason to be heavy in stocks.

Fed policy is and will be hostile to the markets for many months to come. The Fed has set a schedule to reduce the size of its balance sheet and get to a “normalized” reserve position. That will last well into the year 2020, unless the market and the economy force the Fed’s hand to reverse course. That will certainly happen at some point. But by that time, the damage will be done.

This will not be a flash in the pan 6 month, 20% bear market. It will be a more typical 18-30 month affair that will take stock prices much lower. When a bear market is confirmed, I would use the next rally to raise cash to the 80-100% level. There will be ample opportunity to get back in at much lower prices later.


Lee Adler

2 Responses to “Bonds Up, Stocks Down – The Sinister Truth Behind March’s “Portfolio Rotation””

  1. Lee, I really appreciate your knowledge of fund flows and its impact on the markets. I am trying to get some of these relationships straight, and would appreciate any insights you might have. Here are the dynamics that I am trying to get straight:
    – The Fed pulls money out of the system through its reverse QE program. It does this primarily by not repurchasing bonds, MBS, etc. which causes the supply of bonds to rise, prices to fall, and rates to rise.
    – The Fed raises interest rates, which also causes yields to rise and prices to fall
    – The Treasury issues more bonds to pay for deficit spending and to replenish reserves, so the supply of bonds increases, yields rise, and prices fall
    – The money to purchase this new supply of bonds (with safe high interest rates) drains money out of the stock markets and stock prices fall
    – International funds flow out of the US as the foreign central banks (ECB and BOJ, et al) slow of reverse their versions of QE, making bond yields rise further and accelerating the fall of stock prices

    Assuming all of the above statements are true, then here are my questions:
    – As “safe” bond yields rise, won’t investors leaving higher risk assets cause a higher demand for bonds and stabilize the yields at some balance point (say 3-4%) where the risk free rate is basically equal to the risk adjusted rate of stocks?
    – If the Fed drains dollars out of the system, won’t that cause a reduction of supply in dollars and force the dollar to strengthen?
    – If interest rates rise, won’t that hammer all the sovereign and private entities that have record levels of debt?
    – If the dollar strengthens, won’t that make dollar denominated debt very hard to pay (for emerging market economies in particular)?
    – if the dollar continues to strengthen won’t that hammer commodity prices (like oil, raw materials, and agricultural products)? Commodities are a major component of inflation. If commodity prices fall, then inflation should fall, right? And bond yields anticipate future inflation, correct? So if there is price deflation, rather than price inflation, then bond prices should also fall, right?

    I know that you can’t take the time to reply to me privately. But if you need fodder for future articles, anything you could do to address some of these dynamics would be appreciated.


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