Even before an extremely disappointing set of flash prints from IHS Markit’s February PMIs cast doubt on the assumed immunity of the US economy to the fallout from the coronavirus, markets were in flight-to-safety mode on the last day of the week.
China doesn’t see a “turning point” in the epidemic just yet, CCTV said Friday, citing a politburo meeting. Containment efforts in Hubei were described as “rigorous and complicated”.
Of course, if you’re a market participant, that just means the monetary and fiscal response will be even more robust from the world’s second-largest economy.
But the implicit promise of fiscal stimulus and more monetary policy easing did little to calm frayed nerves, and the contractionary print on IHS Markit’s composite gauge for the US economy exacerbated worries.
30-year US yields hit a record low, as the “duration infatuation” is not only back with a vengeance, but in fact now borders on the kind of frantic bond rally witnessed during August’s recession scare.
As Treasurys persist in flight-to-quality bull flattening, you should note that hedging flows are once again magnifying the move.
Swap spreads tightened into the rally on Friday, and as Bloomberg’s Edward Bolingbroke wrote , Thursday saw similar moves with “footprints of dealer hedging of swap-widener positions linked to Formosa issuance”, although some desks I spoke to on Friday weren’t aware of any such hedging activity.
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“Same ol’ Friday ‘hedging into the weekend’ pattern developing again overnight in US Rates / USTs”, Nomura’s Charlie McElligott remarked. “We’re seeing a pretty powerful ‘bull-flattening’ thanks to flows which began out of Asia”.
Bloomberg’s Bolingbroke underscored the point. “Emergence of Japanese lifer accounts supported long-end Treasuries over [the] Asia session and were active in buying ultras [while] Japanese accounts also extended positions further out the curve, buying in 30s vs. selling in belly of the curve”, he said, citing a US trader.
When it comes to the mechanical hedging flows that again look to be pressing long-end yields lower, it’s important not to dismiss the dynamic as indecipherable arcana that the average investor need not even try to fathom. When these flows conspire with a negative macro catalyst, the duration rally is magnified and with it, the the bull flattening impulse.
“Going into yesterday morning, I was actually comparing the feeling of the recent extension of the incredible performance in ‘Duration Sensitives’ to that of last August in a number of client conversations”, McElligott said Friday, before taking a trip down memory lane and recapping the August episode as follows:
When the negative US / China trade rhetoric peaked-out, tilting the “end of cycle slowdown” theme into an outright “recession scare” [it] ultimately drove a “negative convexity” event in US Rates, as the rally was so extreme that it “mechanically” forced MBS players in to convexity hedge and “buy the highs”. As such, last August saw a BIBLICAL “bull-flattening” in UST curves (5s30s from 76bps Aug 1st to 52bps by Aug 14th) which then dictated a preposterous +18% RALLY in US Equities “1Y Price Momentum” factor.
Now, here we are again with another negative macro theme (the virus this time, instead of the trade war) catalyzing a growth scare and an attendant flight to quality. That drives yields lower, and ultimately triggers mechanical buying and hedging flows, all with the effect of creating a mad duration dash, or at least the appearance of one.
The signaling effect of plunging long-end yields (and “biblical bull flattening”, as McElligott colorfully describes it) shouldn’t be underestimated. Although the snap-back during September was all about under-the-hood factor rotations in equities land (i.e., dispersion, not directionality at the benchmark level), August’s bond rally and the inversion of the 2s10s had a demonstrable effect on investor psychology. Donald Trump took notice, calling the inversion “CRAZY” in an infamous tweet.
The point: Make sure you know what you’re looking at when you see yields plunging. Sure, a lot of it is macro-related and, at the current juncture, tied to voracious demand for USD assets. But some of it is a mechanical, hedging-flow pile-on.
At a more basic level, nobody wants to carry risk into these “virus weekends” – it’s reminiscent of the “Greek weekends” from summer 2015.
Meanwhile, the previously bulletproof dollar slumped on the heels of the disappointing PMIs. The greenback was on track for its worst day of 2020.
