(Still) The Most Underappreciated Tail Risk

Towards the end of “Where Were You When The World Didn’t End?“, I reminded folks that although 2020 has so far been defined by bonds’ stubborn unwillingness to selloff, one of the biggest tail risks out there remains a sudden resurgence of inflation and a concurrent disorderly bear steepener.

That outcome seems wholly far-fetched at the current juncture. The Fed and the ECB are engaged in wholesale rethinks of their policy frameworks in an effort to figure out how to counter structural disinflation, and so far in the new year, it’s not higher yields that are a problem, but rather the long-end’s recalcitrance thanks to a bullish seasonal and a safe-haven bid associated with a pair of left-field catalysts in the assassination of Qassem Soleimani and the outbreak of a deadly respiratory illness.

In the simplest possible terms, the curve has flattened and 10-year yields in the US are sitting at YTD lows, in what amounts to a tacit rebuke of Q4’s reflation optimism.

But, again, we shouldn’t forget that an explosive bear steepening episode that forces a disorderly unwind of the still-entrenched “duration infatuation” (in all its various manifestations) would likely be highly destabilizing. As my good friend Kevin Muir points out whenever he gets the opportunity, inflation is the most underappreciated risk in the market today. And it’s always the one nobody sees coming that sparks the next crisis.

With all of that in mind, I would again suggest that even if the tail risk described above is never realized, it’s not likely that bonds will be as effective a hedge for equities as they have been over the past couple of decades.

Indeed, BofA reminds you that the kind of diversification benefits investors have become so accustomed to is a fairly recent phenomenon.

“The core premise of every 60/40 portfolio is that bonds can hedge against risks to growth and equities can hedge against inflation; their returns are negatively correlated, but this assumption was only true over the past two decades and was mostly false over the prior 65 years”, the bank writes, in a piece questioning the future viability of the vaunted 60/40 strategy which forms the foundation of most starter portfolios.

“The big risk is that the correlation could flip, and now the longest period of negative correlation in history is coming to an end as policymakers jolt markets with attempts to boost growth”, the bank goes on to say.

(BofA)

Describing the problem going forward, BofA doesn’t mince words, and some of the words they use echo the warnings from the linked post above. Consider this refreshingly concise passage (the full note is more than a dozen pages long, mind you):

In the past 3 years, the risk-adjusted returns in Treasuries were worse than in every other asset class except commodities; the future may look very much like the recent past, as duration risk is at record highs (G0Q0 = 7yrs), forward-looking implied volatility is at 4-year highs, and the yield per unit of risk is worse than in every other part of fixed income. Long Treasury bond buyers recently enjoyed one of the best periods of returns in history, something unlikely to be repeated. These are not far-off risks, they are happening today.

Over there in the right pane shows investors being chased out the risk curve and down the quality ladder in search of yield, and BofA also notes that “crowded positioning means that natural swings in bond prices may be exacerbated as active investors rebalance their holdings or the macro outlook changes”.

In other words, the duration infatuation creates a situation where subtle, naturally occurring moves are exacerbated, and as we saw in August, dynamics not fully appreciated by all investor cohorts (dynamics like convexity flows) can magnify price action even further. Although August’s tumult obviously saw yields plunge, you’ll recall that the subsequent snapback in early September was violent indeed, which is a testament to the notion that crowded positioning is conducive to swings in either direction.

Again, the idea of a destabilizing bond selloff may seem far-fetched at a time when the economic community is obsessed not with controlling inflation, but with generating it in the face of seemingly intractable structural factors. But then again, that may be even more reason to worry. That is: What if central banks succeed?

BofA goes on to cite three potential catalysts that could “send bonds into a new regime of higher yields”: a housing boom encouraged by refi activity, wage inflation and, of course, fiscal policy.

To be sure, this risk is on the radar, even as it’s most assuredly underappreciated. The latest edition of BofA’s Global Fund Manager survey has “bond bubble pops” as the number 3 biggest tail risk, and “Long US Treasurys” as the fourth-most crowded trade.

(BofA)

Ironically, “monetary policy impotence” was the number 4 tail risk.