Who are the predominant forces in the bond market ?

"Who are the predominant forces in the bond market?"

Despite common belief linking entities like the Fed or foreign Central Banks such as the Bank of Japan or the People's Bank of China to this role, the truth differs significantly.

In reality, the true heavyweights in the bond market might rekindle their interest in bonds by 2024.

Over 70% of net buying flows in Treasury markets stem from pension funds, asset managers, insurance companies, and foreign investors.

Among these foreign investors are institutional players like pension funds and asset managers, in addition to foreign Central Banks. My approximation suggests that foreign Central Banks contribute to around one-third of the flows in the dark green segment.

This leaves approximately 60% of buying flows attributed to the real powerhouses: pension funds, asset managers, banks, and insurance companies — not the Fed.

The Fed's significant role was mostly limited to 2020-2021 due to exceptional pandemic-related QE programs.

Recent buying flows have predominantly come from households. Attractive risk-free rates of 4-5% have made bonds a favorable investment option for the first time in many years. However, it's worth noting that this definition of ''households'' includes hedge funds, so it requires a degree of caution.

The crux of the matter remains: banks, pension funds, asset managers, and insurance companies are the primary whales in the bond market.

But why do they invest in bonds?

These entities find bonds appealing due to their guaranteed (real) yields, which help meet return objectives while hedging interest rate risks effectively.

Insurance companies and pension funds bear long-term liabilities such as life insurances or pensions payable in 30-40 years. To mitigate interest rate risk from these extended liabilities, they invest in long-duration assets like 30-year bonds.

Moreover, these industries aim for long-term return targets of at least 6-7% to sustain viability over the years. Currently, they can potentially achieve both objectives by investing in 30-year BBB corporate bonds, offering a solid proposition for these market whales.

Bonds serve as portfolio stabilizers during times of market volatility for risk assets.

A crucial chart by Dan Rasmussen of Verdad Capital illustrates this point. Over nearly 200 years, it's evident that the stock/bond correlation isn't consistently negative; it often tends to be positive, especially when core inflation surpasses 3% and exhibits high volatility (similar to the trends seen in 2022).

This positive correlation occurs because high and unpredictable core inflation prompts Central Banks to tighten policies aggressively, leading to simultaneous sell-offs in bond markets and declines in equity valuations.

Conversely, bonds maintain their favorable negative correlation with stocks when core inflation predictably falls below 3% (green area). In this scenario, if equity or credit markets experience significant downturns, Central Banks tend to intervene, causing bond markets to rally in anticipation of easing.

In Conclusion:

Currently, with core inflation at 4% and a six-month underlying trend reaching 3%, historical data suggests that the sought-after negative correlation between stocks and bonds might resurface when core inflation falls below 3%.

In such a scenario, bonds could become highly attractive assets for eager whale buyers.

The amalgamation of a long-duration asset that mitigates interest rate risks, offers a high yield, and shields portfolios during equity downturns presents an irresistible opportunity for major bond market players.

These significant market whales have been relatively inactive, but their potential impact could surpass that of the Fed.

It's essential to remain cautious of the stock/bond market correlation and be mindful of the bond market whales' influence.