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The Bond Market Woke up and Chose Violence

“No Mr Bond… I expect you to die.”

As an astute investor noted today, yield curves re-steepen (un-invert) as long bonds worry about inflation if the Fed has completed the tightening cycle too soon. Furthermore, yield curves tend to un-invert just before a recession or when something breaks. The move in price/yield over the past 48 hours at the long end of the curve has been rapid, violent, and emotional.

From our perch, as we indicated this week, the move has probably reflected a capitulation in consensus positioning and beliefs. Our sense is that long only institutional investors had extended duration over the first half of the year as a hedge for the “hard landing” and now feeling the pain. In contrast, CTAs, and speculative investors (including a high profile one) have been net short recently. The rise yields (fall in bond prices) are probably not a simple function of increased supply or the downgrade by Fitch.

Perhaps the fixed income markets also reflect a fear that the Fed might pause too soon? Annual inflation might base here (around 3%) above the Fed’s target and start to accelerate again over the coming months. Base effects suggest that is possible and especially given the 11% rise in commodity prices over the past few months (chart 1).

Recall that there is a high correlation between the change in oil prices and headline inflation expectations. While commodity prices are relative producers win with high prices while consumers lose, the fact is that there is a link between headline inflation expectations and energy prices (chart 2).

Curiously, there is a very large divergence between the Conference Board leading index and the 10-year Treasury yield. Acid Capital (and others) with a long duration bias suggest that the probable hard landing (recession) and recent goods price disinflation warrant much lower yields. That is, the divergence is likely to close by long end yields falling (chart 3). In contrast, the performance of equities with cyclical characteristics versus defensives is consistent with the recent price action in the fixed income markets and the resilient macro conditions (chart 4).

Our fear is that the increase in bond volatility itself (in a Sharpe ratio world) is probably not bullish for equities. Both recent episodes of bond volatility (UK GILT pension fund and the US regional bank episode) contributed to a major value-at-risk shock (de-grossing and forced reduction in leverage) when the Bank of America MOVE index spiked 75% (chart 5). We also can’t help but feel that the recent move might be related to or an unintended consequence the shift in the Bank of Japan’s YCC target (peg) amplified by the other contributing factors above (Treasury supply, trough cyclical inflation and questionable fiscal policy -chart 6).

Tactically, for our portfolio we have been “standing aside” and have zero sovereign bond exposure. The leading indicators suggest that the problem will likely be resolved by yields falling once growth responds to policy tightening with a lag. However, in the near term higher fixed income volatility and yields (discount rates) might also be challenging for equities.

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