Timing bear markets is never easy, but it’s even more so with fixed income.
When they do occur, they are often fairly quick in nature.
Both instances of sovereign bonds cheapening in 2018 have been characterized by such behavior.
In February, stock markets were roiled by the 40 basis point rise in 10-year U.S. yields . Yields have an inverse correlation to a bond’s price. This precipitated a stock market volatility shock and a big jump in the VIX index — which is used as a fear gauge with the broader market.
Interest rates on government debt have stabilized since then, even with the Federal Reserve hiking twice — which usually sends bond yields higher. From May onwards, 10-year U.S. Treasurys held on to a holding pattern of between 2.8 percent and 3 percent .
That’s all changed in the last month with the cumulative yield rise in September amounting to 45 basis points, the final 18 basis points occurring last week alone and putting the 10-year note at 3.25 percent, a level not seen since May 2011.
U.S. stock markets are beginning to take note as investors get nervous about the future returns of equities in a higher interest rate environment. Treasury yields are used to price the interest on all sorts of loans across the U.S. And if borrowing becomes more expensive then there’s a belief that some companies could start to be squeezed. Investors have therefore started to evaluate the merits of holding growth stocks in a late cycle environment.
There are certainly many reasons to be negative on fixed income at this juncture:
Inflation is on the rise which is traditionally bad for holding bonds. The trend for average hourly earnings has been on an upward slope for the past year, in fact Citi analysts calculate that on a quarterly basis, average hourly earnings are pointing toward a 3.5 percent growth level — the highest level since the global financial crisis of 2008.
The Fed has been slowly reducing the size of its balance sheet, allowing its portfolio of Treasurys to run off. The Fed’s balance sheet reduction policy has meant that the financial system is less flush with liquidity and with the U.S. dollar.
Foreign purchases and positioning
The strengthening dollar this year, also associated with higher funding costs, has made U.S. Treasurys less attractive to own for foreign accounts who would typically hedge their portfolios with U.S. bonds.
Indeed, data from the Commodity Futures Trading Commission last week showed stretched short positioning in the 10-year sector, indicating a desire from the investment community to rotate out of their bets against short-dated fixed income into longer-dated notes.
Combine all this with the fact that the U.S. is also in the midst of an expansionary fiscal policy. In August, gross Treasury issuance topped $1 trillion for the first time. Net issuance is at its highest level since 2012, according to Securities Industry and Financial Markets Association data. While most of the extra issuance has occurred in short-dated debt, the market is still concerned about high budget deficits in years to come.
Reasons to be bullish
Nonetheless, some fixed income traders are saying the recent correction in bond yields may be coming to an end.
Since the crisis, central banks have injected trillions in liquidity into the financial system via quantitative easing (government bond buying). About a quarter of all bonds in the world still have a negative yield. Many traders argue that as long as the European Central Bank and the Bank of Japan continue with accommodative monetary policy, there are only so many places investors can park cash to get a decent return. The U.S. bond market is one of those.
From a risk-reward perspective, investors will be more inclined to opt for “risk-free” assets with less underlying volatility (such as U.S. Treasurys) rather than riskier credit or emerging market debt.
Furthermore, the U.S. debt market may also benefit from domestic pension fund de-risking.
The prevailing view in the market is that given the size and speed of this move, it may be wise to take some chips off the table. But the bearish narrative is certainly there. Stock investors, take note.