This Bond Bull Market Still Has Legs


by Jim Rickardfs, Daily Reckoning:

I started in the Treasury bond business in 1985 after a 10-year career in commercial banking. I retired as a senior officer of Citibank that year at a relatively young age and made the move to Wall Street.

My firm was Greenwich Capital Markets, one of a select group of “primary dealers” allowed to transact directly with the Federal Reserve. Monetary policy is conducted through open-market operations run by a trading desk at the Federal Reserve Bank of New York.

Being a primary dealer just means you have passed rigorous screening by the New York Fed in terms of credit, capital, operations, management and other criteria.

Importantly, as a primary dealer you have to make a continuous two-way market in all maturities of U.S. Treasury and government-backed mortgage securities across the yield curve. You are expected to buy when others are selling and to sell when others want to buy.

That market-maker role is how the Fed insures liquidity in the Treasury market and is the price a firm must pay for the privilege of being named a primary dealer.

Greenwich Capital was small but mighty. We did not have the capital size of other primary dealers like Goldman Sachs or Morgan Stanley, but we did have a reputation as having some of the smartest sales and trading staff around. We punched above our weight as a market maker.

As the firm grew, we were frequently ranked in the top five and sometimes No. 1 in certain parts of the yield curve, particularly 10-year Treasury notes. Our customers were the biggest firms in the world such as PIMCO, MetLife and giant foreign banks based in Japan and Germany.

As a member of the executive committee at Greenwich, part of my job was staying in the good graces of the Fed and making sure nothing jeopardized our primary-dealer status. If the Fed had ever pulled our name off the primary-dealer list, our customers would have abandoned us the next day.

I became a regular in meetings at the Federal Reserve Bank of New York. That experience served me well years later, in 1998, when I had to negotiate the bailout of Long Term Capital Management sponsored by the New York Fed.

There was something else highly memorable about my time at Greenwich Capital. It was a money machine! The firm typically had returns on equity of 20–40%.

That was partly because we were smart, savvy and hardworking. But there was another reason. Our firm had caught the wave of the greatest bond bull market in history. It was hard not to make money.

This 30-year chart below shows the declining path of interest rates on the 10-year Treasury note from 1988–2018.

This bull market in bonds actually began in 1981 after Paul Volcker pushed short-term interest rates over 20%, the highest since the Civil War, to kill the runaway inflation of the late 1970s and early 1980s.

Although there were rallies and drawdowns along the way, and plenty of chances to lose money — such as the bond bloodbath of 1994 — the overall trend is clear. Bond yields have fallen and bond prices have rallied for over 30 years:

To understand why this bond bull market was such a source of profits for Wall Street, including my old firm, a bit of simple bond math is in order.

The first point is that bond prices move inversely to yields. If interest rates are going down, bond prices are going up and vice versa. A declining interest rate environment is heaven-sent for a bond dealer with inventory or an investor with bonds in her portfolio. That’s what the chart shows.

The second point is that the amount of capital gain on a bond in a declining rate environment increases as the absolute level of rates declines.

For example, a 1% rate decline from 2% to 1% produces a much larger capital gain than a 1% rate decline from 8% to 7%. The reasons are highly technical and involve concepts such as “duration” and “convexity.”

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