Last weekend, we attempted to dissect the latest selloff in U.S. Treasurys by decomposing rate rise and drawing some possibly useful conclusions about what might come next for bonds.
In that linked post, we contrasted last week’s dynamics (breakevens widening and signs of the term premium trade leading nominals higher) with the broader trend which has seen reals leading the way since the August lows.
There are a number of ways this can play out going forward and you can read the details there for yourself, but if one wanted to posit a kind of worst case scenario (and inherent in that characterization is the notion that such a scenario is unlikely), a sharp acceleration in inflation pressures (from a string of above-consensus AHE prints or upside surprises in CPI, for instance) could trigger a bond rout and because the current Fed seems inclined towards data dependence, higher inflation would likely push real yields higher as the market anticipates a hawkish turn.
Higher real yields is obviously bad for risk assets and depending on the pace of rate rise, an acute bond rout could flip the stock-bond return correlation positive, triggering forced de-risking by risk parity and other multi-asset strats.
Again, there are all manner of caveats there, not the least of which is that the term premium remains suppressed…
… and, assuming you take spec positioning at face value (not necessarily a safe assumption), the near-record duration short could be a contrarian indicator.
Well, speaking of the term premium, Nedbank’s Neels Heyneke and Mehul Daya are out with a new note and in it, they remind you that “a sharp rise in the US 10-year Treasury bond yield, accompanied by a rise in the US risk premium, has triggered a number of downturns in financial markets and the global economy since the 1990s.” Have a look:
Obviously, the term premium debate is long and winding and I don’t want to get too far into the weeds on that here. What I would quickly note is that the stubbornness of the term premium has confounded many an analyst over the years and recently, Goldman revised their Treasury yield forecast lower citing that stubbornness.
For the above-mentioned Neels Heyneke and Mehul Daya, episodic bouts of term premium rebuilding in 2018 are attributable to “foreign holders of US Treasuries like China and Japan slowing their rate of purchases and rising offshore US dollar funding costs (hedging) eroding returns for foreign investors.” You’d think that eventually, the deterioration of the U.S. fiscal position would also impact this situation, but so far so good (read: no disasters) when it comes to Steve Mnuchin selling debt to finance Trump’s deficit-funded stimulus measures.
In any event, Nedbank goes on to list the three areas that are most vulnerable should 10Y yields (and thus the global cost of capital) continue to rise, and we’ll present the list without further comment as it speaks for itself…
- Leveraged investment strategies: the rising cost of global capital will not bode well for leveraged investment strategies, like the infamous carry trade, which has been a tailwind for emerging markets. We believe risk parity- and CTA-based strategies are also vulnerable and will be further exposed due to the lack of market liquidity.
- Stock markets, especially those with stretched valuation metrics. The US, for instance, is particularly overvalued amid the boost from share buyback programmes.
- Corporate leverage: slowing global growth, coupled with a rise in funding costs, will not bode well for heavily indebted corporates, particularly corporates with large amounts of cross-border US dollar-denominated debt. EM corporates, in particular, are vulnerable, as US dollar credit exceeds their FX reserves and export earnings by 50%, on average.