The Real Risk For Markets: The Bond Bubble Bursts

Over the weekend, in the course of documenting what ended up being the best month for US government bond returns since 2008, we gingerly suggested that while a benign rise in yields would be highly desirable to the extent it would suggest slowdown/deflation worries are fading, a quick upward “correction” (i.e., a rapid bond selloff) could be highly destabilizing.

Market participants have learned to fear tantrums in the post-crisis world. Central bank asset purchases have impaired the functioning of government bond markets (obviously more so in Japan and Europe than in the deep market for USTs) and with yields sometimes prone to overshooting to the downside, “tantrum” risk is always lurking in the background.

Of course, that risk is larger or smaller depending on a variety of factors including positioning and the macro backdrop, but the point is, with everybody on one side of the boat after the mammoth bond rally, markets likely wouldn’t be able to digest a rapid rise in yields with anything that even approximates alacrity. As we put it on Saturday, “one has to be concerned that any sudden bear steepening would risk kicking off a tantrum, which could be even worse than a continuation of the rally”.

Read more: Markets Just Witnessed The Best Month For US Government Bond Returns Since 2008 — What Now?

BofA’s Michael Hartnett underscores that risk in last week’s “flow show” note, which grabbed headlines for the contrarian “buy” signal his Bull & Bear indicator flashed for risk assets.

While the bullish stocks (and commodities) call was what grabbed the clicks, the more important bit was in the nuance about bonds. Hartnett captured it while juxtaposing the “positive shock” from the potential “negative shock”.

“The positive shock risk is [an] orderly rise in yields and Great Rotation from bonds to stocks as policy makers successfully postpone recession”, he wrote, before detailing the negative risk as follows:

The negative shock: -ve risk is bond bubble bursts causing disorderly rise in yields. Surging bond prices + surging bond inflows + belief central banks will underwrite bond prices = bubble. [A] disorderly rise of interest rates could cause Wall St deleveraging [and] deleveraging in public & private markets as investors leveraged to everlasting low rates and thereafter a Main St recession.

So, while the recent duration grab (i.e., manic bond rally) has been associated with higher rates vol., a flatter curve and recession fears, don’t let it be lost on you that the real risk might well be a bond selloff that sees yields rise too far, too fast, catching everyone woefully wrong-footed.

“[A] record $160bn inflows to bond funds the past 3 months reveal deep global recession fear and global capitulation into the ‘Japanification’ theme”, Hartnett writes, before cautioning that “big bond inflows often precede big policy changes [and] periods of big bond outflows coincide with the most bearish returns across asset classes”.

(BofA)

Fair warning.