Is Selling Bonds the Taste of Things to Come?

Posted by Mike "Mish" Shedlock: Global Economic Analysis

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Treasury yields are on the rise as I have noted on numerous occasions recently.

The action has prompted the world’s largest hedge-fund manager, to throw in the towel on treasuries and inflation-linked TIPS.

imagesEd Note: Canadian Bonds Plunge with U.S. Treasurys After Strong Data

Canadian Bonds Plunge with U.S. Treasurys After Strong Data 

Please consider Dalio Patched All Weather’s Rate Risk as U.S. Bonds Fell

As the bond market plunged in late June, Ray Dalio convened the clients of Bridgewater Associates LP, the world’s largest hedge-fund manager, to tell them that a fund designed to withstand a broad range of market scenarios was too vulnerable to changes in interest rates.

Bridgewater, citing months of study, said it had underestimated the interest-rate sensitivity of various assets in its All Weather fund and was taking steps to mitigate the risk, according to clients who listened to or read a transcript of the June 24 call. By the end of the month, the Westport, Connecticut-based firm had sold off enough Treasuries and inflation-linked bonds to help reduce the fund’s most rate-sensitive assets by $37 billion, according to fund documents and data provided by investors. 

The move, disclosed to investors five days after the Federal Reserve said it’s prepared to phase out its unprecedented bond purchases, was unusual for the fund. As its name suggests, All Weather is designed to produce returns in most economic environments and avoid altering asset allocations when the outlook changes. All Weather incurred a second-quarter loss of 8.4 percent that was primarily tied to its $56 billion portfolio of inflation-linked debt, said the clients, who asked not to be named because the fund is private. ‘A Foretaste’

The decline at All Weather and similar funds, including those run by Cliff Asness’s AQR Capital Management LLC and Invesco Ltd. (IVZ), shows Bridgewater’s pioneering strategy for allocating assets between stocks and bonds, known as risk parity, can leave investors overexposed to rising interest rates. The losses were amplified for some funds by a selloff in inflation-linked securities that also caught Bill Gross’s $262 billion Pimco Total Return Fund (PTTRX) off guard.

“This is just a foretaste of what is going to happen,” said Ramin Nakisa, a global asset-allocation strategist at UBS Investment Bank who co-wrote a March research report titled “When Risk Parity Goes Wrong.” Nakisa called June’s selloff in Treasuries and inflation-linked bonds “a dress rehearsal” for the volatility awaiting when the U.S. Federal Reserve actually begins to taper its bond-buying program, known as quantitative easing.

All Weather trimmed its use of leverage to about 144 percent of net assets at the end of June, according to the clients who requested anonymity. Gross exposures to different asset classes declined to about $116 billion from $138 billion in the quarter, while net assets stayed at $80 billion.

Reflections on Leverage

Lovely. All Weather now has a mere 144 percent leverage? What happens if stocks, bonds, and commodities all take a dive?

Here’s the deal: This selloff in treasuries may be over. Or it may not be. Anyone who thinks they know is fooling themselves.

What I do know is leverage works both ways. I also know that the Fed has so distorted the economic horizon that it is next to impossible to predict what’s coming down the pike.

Stocks, bonds, and commodities other than gold all rose in union over the past few years. My bet is on an unwinding of that trade.

I see no value in treasuries, no value in corporate bonds, no value in equities, and no value in municipal bonds.

I do see value in gold, so that is where I am. Without leverage. Patiently waiting.

Mike “Mish” Shedlock