Questioning ‘Life Above 2%’ And Pondering The ‘Long-Dated Rates Catastrophe Option’

“As traders head into 2020, the question is, is there life above 2%?”, a Bloomberg article previewing the holiday-shortened week muses.

The gist of it is simple: 10-year yields stateside have looked poised to rise above 2% and beyond on several occasions over the past eight weeks or so, and we’ve never managed to get over the hump.

A week after Donald Trump first tipped the “Phase One” trade deal with China in October, Boris Johnson managed to cobble together a Brexit deal that was some semblance of acceptable to most interested parties. Since then, bond yields have arguably been waiting for confirmation on the trade agreement and the clearing of political roadblocks in London to take off in earnest.

Appropriately enough, the landslide Conservative victory and the rolling out of the trade deal came within the same 48-hour window, and yet, it wasn’t enough to push 10-year US yields beyond the Maginot Line.

“The year-long rally in core bonds has taken a breather since early September, as the news flow improved and data showed the first tentative signs of bottoming, but since then, bond sell-offs have been limited and struggled to gain momentum”, Barclays notes, adding that despite stocks’ summiting ever higher peaks, yields have been mostly pinned between 1.5 and 1.9%.

For the bank, a large, sustained bond selloff isn’t likely. Here’s why:

We believe that core bonds are fairly priced and do not expect a sustained sell-off (such as UST 10s rising to 2.25%) over the next couple of quarters, for a few reasons. First, investors have already significantly pared back expectations of imminent Fed easing. For a material sell-off, bond markets would need to price in a substantial hiking cycle as the Fed’s next move; we believe this is very unlikely. Given how little inflation pressure the economy has faced over the past decade, even with jobless rates at 50-year lows, we do not think investors will be in a hurry to price in a new series of Fed hikes. Separately, recent Fed commentary and minutes suggest that Fed officials are still primarily worried about downside risks, including on inflation. The hurdle to hikes remains high, to cuts far less so. This makes for an unexciting forecast.

The bottom line, for Barclays anyway, is that while a selloff for bonds isn’t likely, neither is another stellar year like 2019. “Instead, investors should mainly earn coupon; our forecast for 10y UST is 1.7% next year”, the bank says.

Given all of this, and considering the myriad structural factors weighing on inflation (not to mention the malfunctioning price Phillips curve and the extent to which the disinflationary impulse has a tendency to become self-fulfilling), it might seem odd to even bother pondering an outcome where yields rise too far, too fast, in a tantrum scenario.

And yet, don’t forget that in 2018, both major equity selloffs started with surging 10-year yields and concurrent worries that the virtuous negative correlation between stock and bond returns was on the verge of flipping positive, leading to diversification desperation. That’s easily visualized with the following simple chart which is just weekly returns for the long-bond ETF and the VIX.

Although it was the realization of the rebalance risk inherent in the inverse and leveraged VIX products that technically caused “Vol-pocalypse” (on February 5, 2018), the setup involved sharply higher yields. The above-consensus average hourly earnings print that accompanied the January jobs report on Friday, February 2, 2018, was the straw that broke the camel’s back.

In any event, consensus is that even if yields were to suddenly move up to ~2.50%, stocks would be fine, assuming the bond selloff was predicated at least in part on better growth outcomes.

But, as Harley Bassman reminded subscribers in his 2020 outlook earlier this month, if yields were to spike beyond, say, 4%, it would be “lights-out”.

Fortunately, he doesn’t think that’s likely.

“Notwithstanding my view that the Yield Curve will steepen, most of my investments have a long bias to interest rates since bond rates should not run away to the upside”, Bassman said. “I believe the T10yr is capped at 3.5% until 2023”.

Below are some additional excerpts which are highly germane in the context of the discussion above. We should note that this particular trade (labeled “Long-dated interest rate catastrophe option”) is for professionals only.

Via Harley Bassman (from a commentary dated December 3)

Despite my confidence that long-dated interest rates will not exceed 3.5% for the next five years, if I am wrong, it will be ‘lights-out’ for the financial markets. I have often highlighted the –cyber line– correlation between Stocks and Bonds; how their prices have moved in opposite directions since the Great Financial Crisis (GFC). Functionally, this creates a self-hedging portfolio if weighted between these two assets.

Evidence suggests this correlation will reverse if interest rates rise above 4.0%; at that point both stocks and bonds would decline in unison. With almost perfect serendipity, the –hellebore line– cost to mitigate this risk is near its decades low.

Buy a 10yr into 20yr payer swaption (put), Strike = 4.5%, Px = 135bps. This trade is effectively a ten-year option on the TLT ETF, struck at 95. While not a great substitute, I suppose one could buy the listed January 2022 expiry put struck at 100.