‘Normal’ Is A ‘Funny Concept,’ One Bank Reminds You

“Sell Treasurys and trust the expansion.”

So said Morgan Stanley’s Andrew Sheets on July 18.

I should emphasize that the note from which those half-dozen words were plucked was a good one. Be that as it may, the market wasn’t in any mood to sell bonds or trust the expansion come Monday. Indeed, the bond rally accelerated dramatically, pushing 10-year yields in the US down another ~10bps (figure below).

The risk-off optic from rates likely amplified already sour sentiment in equities. Wall Street crumbled.

The Treasury ETF (TLT, I mean) was on pace for its second-best day of 2021. It’s overbought for the third time in a month. It was deeply oversold in late February, when the four-decade bond bull purportedly perished, at least on some indexes. It appears we were too early in writing its obituary. Lacy Hunt is laughing. So is Albert Edwards.

As Bloomberg noted Monday, the combined net short for hedge funds in 20- and 30-year Treasury futures rose to the highest since February last week (figure below).

“The best explanation for recent price action in Treasurys is positioning and flows, rather than any fundamental change in the outlook for the economy, r*, or the Fed’s stance,” Morgan Stanley’s Guneet Dhingra said.

I’d have to agree, but there was little question on Monday that concerns tied to the Delta variant were contributing to the haven bid. It may not be that market participants actually fear another economic downturn. It could simply be a case of “If I think you think a growth scare is coming, I’ll try to front-run you.” When you set that against a deluge of COVID headlines and unfinished short-covering business, you end up with an exaggerated rates rally and more bull flattening.

As anomalous as the past year was on so many fronts, Morgan’s Sheets wrote that, paradoxically, most “normal” cycles are in fact unusual. “‘Normal’ in markets is a funny concept, with the rough edges of memory often smoothed and polished by the passage of time,” he said, before reminding market participants that,

The cycle of 2003-07 ended with the largest banking and housing crisis since the Great Depression. The cycle of 1992-2000 ended with the bursting of an enormous equity bubble, widespread accounting fraud and unspeakable tragedy. ‘Normal’ cycles are nice in theory, harder in practice.

But their peculiarities notwithstanding, cycles exhibit patterns. For Sheets, many of those patterns were present this time around, just as they were in previous cycles. To wit:

Was last year’s recession preceded by late-cycle conditions such as an inverted yield curve, low volatility, low unemployment, high consumer confidence and narrowing equity market breadth? It was. Did the resulting troughs in equities, credit, yields and yield curves match the usual cadence between market and economic lows? They did. And were the leaders of the ensuing rally the usual early-cycle winners, like small and cyclical stocks, high yield credit and industrial metals? They were.

So, this cycle appears a semblance of normal. As unusual as it most assuredly was.

That being the case, Sheets reckoned it should continue to progress along a reasonably predictable trajectory, or at least in the market context and albeit on a truncated timeline.

The compressed nature of the current cycle is, he said, “powered by enormous policy support.” Unprecedented policy support means a hotter cycle. And a hotter cycle should be a shorter cycle.

Among other things, that suggests “interest rates are too pessimistic on the recovery,” he wrote, before citing the above-mentioned Dhingra. The bank’s US rates strategy team is now underweight 10-year Treasurys. Sheets, in turn, said he’s “moved back underweight government bonds” in the bank’s global asset allocation.