‘Duration Frustration’ Seen As Defining Market Feature

“Investors need to manage explicit or implicit duration risk from income-generating assets and strategies,” Goldman’s Christian Mueller-Glissman wrote, in a new asset allocation piece that featured a section on “duration frustration.”

Time and again over the last several months I’ve highlighted a veritable chorus of warnings on the potentially perilous juxtaposition between a market with a ton of embedded duration risk and the transition to a new macro regime defined by run-it-hot policies and elevated inflation.

This is, in many respects, the only debate that matters. As detailed pretty extensively in “Is Modern Market Structure Ready For A Macro Regime Shift?“, some of the associated questions are almost existential.

While inflation concerns appear to have ebbed a bit (with breakevens coming off and commodities retreating after both staged dramatic run-ups), worries about the compatibility of accumulated positioning in all manner of legacy trades will persist until there’s more clarity on the macro front.

The worry, in a nutshell, is that the return of macro vol could short-circuit things, figuratively and, in some ways, literally.

For my part, I doubt the bond bull is well and truly “dead,” Q1’s technical UST “bear market” notwithstanding. Yet, if you accept the notion that it finally perished after four long decades, you might already be asking yourself if the ensuing bear market is already on its last legs. After all, 10-year yields have stalled, leaving some to wonder if 2% is a pipe dream.

“It may be too early to call the end of the bond bear market,” Goldman’s Mueller-Glissman remarked, noting that the bank’s own targets call for 1.9% on US 10s and 0% on bunds. This time, he remarked, is different in a few respects. “The last cycle was dominated by lingering deflation fears due to the depth of the recession and second-round effects, while this one has started with more inflation optimism due to a reflationary policy mix and less deleveraging pressure,” he wrote.

So where (and how acute) is the duration risk? Well, fixed income is obviously quite vulnerable, with yields low and management teams prone to longer-dated issuance. But, as I never tire of reminding folks, this isn’t a risk that’s confined to FI — not at all. Goldman underscored as much. “Equity duration has increased in recent years and post the COVID-19 crisis due to elevated valuations and the outperformance of low-yielding growth stocks,” Mueller-Glissman went on to say.

Still, stocks can serve as a hedge against inflation. I assume that goes without saying. But it’s a delicate balance and one investors aren’t accustomed to striking.

“Even longer duration equities can have a positive beta to rates,” Goldman remarked, in the same note, adding that since the late 90s, well-anchored inflation, better real growth and central banks’ efforts to “buffer negative growth shocks” meant that rate rise generally happened for the “right” reasons, allowing equities to rise with yields.

But “shocks” (as it were) aren’t easily digested by definition. The “How fast?” (i.e., the rapidity) of rate rise matters at least as much as the “Why?” (i.e., what’s the rationale for higher yields?) when it comes to stocks’ capacity to absorb a bond selloff.

“Speed matters,” Mueller-Glissman emphasized. “Rate shocks can quickly weigh more on equities than on fixed income assets and the beta of secular growth stocks like those on the Nasdaq might remain more negative since last year as embedded LT growth expectations are already high and unlikely to pick up with cyclical growth and inflation.”

“An early 2022 start to [Fed] tapering would align with some market participants’ view of the timeline according to the New York Fed’s Survey of Primary Dealers, but that tapering baseline doesn’t look priced into bond markets based on the level of yields or shape of curve, which is why yields should rise further,” JPMorgan said Friday.

John Normand added that the bank “still think[s] the negative-return assets in that scenario will be pure or quasi-duration assets [like] DM Bonds, HG Credit, lower-yield EM Bonds and Currencies, Defensive Equities, Growth stocks and expensive equity thematics [including] Innovation stocks and SPACs.”