Bonds have been in the news over the past three sessions, but for a different reason than investors are used to this year.
Yields are on the rise both in the US and Germany, where curves bear steepened to start the week, in a break with precedent that perhaps suggests last Thursday’s rout has legs.
10-year Treasury yields are up some 20bps over the past week – yields were 7bps cheaper on Monday on top of Thursday’s dramatic rise.
It may not look like much considering the scope of the August rally, but it’s had a dramatic impact under the hood in US equities, where a brutal Momentum factor unwind unfolded on Monday, much to the chagrin of consensus positioning.
Last Thursday’s bond bloodbath was attributable to a variety of factors including optimism around US-China trade talks, and a buoyant services PMI stateside. The risk, though, is that yields rise too far, too fast, catching everyone wrong-footed and catalyzing a tantrum. As BofA’s Michael Hartnett was keen to point out earlier this month, “an orderly rise in yields and Great Rotation from bonds to stocks as policy makers successfully postpone recession” would be a positive catalyst for risk assets, but a “disorderly rise in yields” which causes the bond bubble to burst could be bad news indeed.
“The Trump-China-Fed 3-player chess game came to a head in August, resulting in a drop in the 10y yield to as low as 1.43% and the biggest monthly bond market rally since 2008”, BofA’s Chris Flanagan said, in a recent note recounting a remarkable August.
But the best month for US government debt since the crisis has left bonds overbought and vulnerable.
“Duration exposure reached a max of the past 20 years during the month and the 10y yield hit the 4th most oversold level (overbought bonds)”, Flanagan went on to remark, adding that “the extreme pessimism of August is poised to give way to a risk-on phase with potential for at least a near term partial retrace of yields higher”.
How far any such retrace runs and, more importantly, how fast it runs, will dictate whether any continuation of the nascent bond selloff is a benign development or a potential destabilizer.
For his part, Hartnett wrote late last week that the most recent flows data shows “zero sign investors [are] worried about a bond bubble, [with] chunky inflows to both IG and government bond funds”.
He went on to note that “investors are not positioned for higher yields” despite the fact that “policy stimulus [is] increasingly fiscal”. Hartnett then ran through some of the recent headlines which together suggest that fiscal stimulus is catching on. “In recent weeks the US ‘explored’ issuance of a 100-year bond, the UK announced a 4.1% rise in government spending, Korea announced a 9.8% rise, China is set to boost infrastructure spend [and] Germany [may] raise spending in case of recession”.
For Hartnett, “the best autumn upside” might just be in “oversold, cheap cyclicals geared to rising yields”.
Suffice to say Monday was a rather dramatic testament to that thesis.