By Annaly Capital Management:

Asset bubbles and leverage are kindred spirits. Just look at housing, tech stocks, and tulip bulbs. But if this is a necessary bubble condition, bonds don’t make the cut. Thanks to data provided by AMG and the Fed, we know there has been real, unleveraged buying behind the bond rally. In fact, many have failed to participate in 2010’s U.S. Treasury market’s climb. As a data point, last week Stanley Druckenmiller, a veteran hedge fund manager, expressed his frustration with missing this year’s bond rally. We surmise he has plenty of company in the hedge fund community.

Real money demand for bonds reaches beyond the Fed’s portfolio activities. Specifically, mutual fund data indicates bond performance has been fueled by long-only traditional investors. This group has been pouring money into the asset class en-mass for two years now. In the table below, we show the cumulative net inflows into mutual funds from 2009 to present. The trends show a stark contrast in asset type preference: income over growth. Consider that money funds, which pay no income, and equity funds which thrive off growth, have either lost assets or held steady.

Fixed income sectors have enjoyed robust inflows. For example, the sizable category of Taxable Bond Funds has witnessed asset growth of a massive 39% due to new-money flow. The bond market has delivered the returns. Consider that the 10-year Treasury note has posted a staggering 18% annualized return this year thanks to a 125 basis point drop in its yield and a little convexity. While the initial impetus of real money to asset allocate into bonds may have been safety and yield, it has arguably morphed into something more fundamental. As the disinflation/deflation concept has become more entrenched in the collective psyche, investors are willing to accept lower long-term nominal yields. The stellar past returns have been more accidental than anticipated. As we noted last week, it appears further disinflation is priced into the current level of U.S. nominal yields. As evidence, consider that 10-year Treasuries are trading 75 basis points rich to JGBs in real terms, a relationship that may be supporting Yen’s recent strength.

So – what will trigger a reversal in the real money flows? This seems critical to the “bond call”. Given that cash, stock, bonds and real estate are the lion’s share of most investors portfolio mix, perhaps we should posit the question differently. When will investors start buying stocks again? Here the deflation theme rings ominous: firms become price takers rather than price makers and earning and margins adjust accordingly. Another factor that may still be vivid in the memories of investors is the realized losses experienced by stocks holders. The below AMG data show, that there was heavy selling of equities at the 2009 lows. Ouch!

Annaly Capital

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