DOES BOND MARKET CARNAGE LIE AHEAD?

JP Morgan recently released their macro view of the markets and the economy and it provides a useful overview of the current environment and how they’re positioned.  They are expecting continued asset reflation in risk assets, but are bearish on bonds and commodities:

• Asset Allocation –– Asset reflation and the search for yield are overwhelming. Don’t fight the central banks, even as the world economy does not impress. Stay long risky assets. Overweight real assets as nominal ones will get hurt when central banks normalize rates, whether on time or too late.
• Economics –– Better data for Asia, but weaker for the US. Downside risk on US Q1 growth, but upside on Asia. We raise Japan H1 from 1.4% to 1.9%.
• Fixed Income –– We keep a bearish tilt in DM bonds, with outright shorts in German Bunds and in Australia.
• Equities –– This month’s Global Manufacturing PMI fell, but is still up on the past 2 months. Keep OW in Cyclical vs. Defensive sectors globally.
• Credit –– Euro high yield offers attractive carry-to-risk.
• Foreign exchange –– FX volatility to stay low.
• Commodities –– Weak refining margins are starting to limit oil demand. We expect prices to fall over the near term and then rebound towards the summer.

The most interesting comments from the note are regarding comparisons to 1994 and the potential for bond market “carnage”:

“But the valid question to the bulls is indeed how long this liquidity-drivenrally can last, and whether we will have to give it all back when central banksstart the eventual QE exit. Many of us remember the carnage in bond markets in 1994 when the Fed hiked rates from 3% to 6% to combat a spike in inflation. Bonds yields had reached new lows in 1993, in response to a mad search for yield after the Fed had held rates at 3% for a year and a half. Many are now wondering whether we are setting ourselves up for a 1994 in size, given that rates will have been held lower and for much longer than in 1992-93 and that G4 QE has reached new extremes. To the bears, the end of QE spells either bond carnage much worse than 1994, or inflation if central banks feel markets and economies cannot handle rate normalization.”

I’ve been bearish long bonds since the beginning of the year as they’ve declined about 4%, but I do think this comparison is a bit off base.  This environment is not remotely similar to the 1994 environment and while I do believe there is upside risk in yields I do not think this environment could morph into a 6% Fed Funds Rate type of environment.  There remains far too much slack in the economy and general sluggishness for such an environment to play out.  While I am not in the 2012 recession camp, I also think that the kind of boom that would be consistent with 6% rates is unlikely….