Why One Bank Isn’t Buying ‘Forced’ Bond Narrative

“We think that it is important to avoid the trap of forcibly fitting a narrative,” Morgan Stanley’s Guneet Dhingra said, in a Sunday note.

Too late! Or, more apt: Ok, fine, but how are we supposed to make sense of markets if we can’t forcibly fit a narrative to the price action?

I’d say I’m just kidding. But I’m not. Our entire lives as market participants are spent fitting narratives. If we “avoid that trap,” as Morgan’s strategist sagely advised, then every financial journalist on the planet would need to find a new occupation, as would most Wall Street analysts.

Without the narratives, what’s left? Just the price action. Just numbers. Just lines moving around on a monitor. And where do those numbers and lines come from? Well, they’re just the result of algorithms (of the organic and inorganic variety) interacting with one another on weekdays. Suddenly, this game seems entirely contrived! (Because it mostly is.)

But Morgan wasn’t trying to make an existential point about the futility of the games we play. Rather, the point was (much) narrower.

The bank reiterated that, as yields rose in Q1, investors forced themselves to believe a story about the bond market pulling forward reflation and re-opening whereas now, market participants are attempting to spin the decline in yields (~50bps from the 2021 peak as shown in the figure, below) as indicative of growth concerns.

I warn regularly about “false optics” in the bond market, where positioning squeezes and flow dynamics not appreciated by the vast majority of market participants can precipitate all manner of stories that don’t necessarily align with reality, or “reality” in the sense we use the term when we discuss markets and the economy.

Morgan blamed the rise in yields earlier this year on Japanese selling and now says there’s “a lack of a credible narrative to explain the large decline in yields.” When considered with “the demonstrable role of positioning,” the bank continues to “see a good case for higher yields from here.” (The title of a July 23 note was “Sell Bonds, Mortimer, Sell!”)

Obviously, I’m sympathetic to that. I’ve spilled copious amounts of digital ink on the extent to which a positioning squeeze which accelerated after the Fed’s hawkish pivot at the June FOMC, created a kind of “Fata Morgana,” which became self-fulfilling as investors once again failed to recognize their own reflection in the mirror. Like a dog barking at itself in a reflective glass window, market participants pointed to the bull flattener, cited rising Delta variant cases and proclaimed a growth scare was upon us.

That said, there’s obviously something to the notion that the Delta variant could dent growth at the margins and also to the idea that a Fed which gets it “wrong” could conceivably tighten into a slowdown. Morgan isn’t buying it, though.

“Most investors mistook the rise in yields as validation for a super-hot economy, and the consensus bought into the idea that 10-year yields were headed above 2%,” the bank said. “Despite the lessons from March, July 2021 looked just like March in reverse,” they added, charging market participants with “fitting a narrative of excessive pessimism to lower yields.” Those narratives, the bank contended, “don’t stand up to scrutiny.”

On the Delta variant, Morgan cited the UK, as do many analysts. Hospitalizations “remained low as cases spiked, the economy reopened anyway and ultimately cases have started receding, suggesting overstated downside risks from COVID-19,” Morgan said, on the way to calling Jerome Powell’s remarks about the virus “reassuring.”

Speaking of Dr. Powell, MD, Morgan doubts the policy mistake explanation for falling bond yields too. It “doesn’t match up with record-low real yields and very high inflation expectations, or even strength in risk markets,” the bank said, before (gently) lampooning assumptions about a lower r* as being “odd at a time when both growth and inflation are running at multi-decade highs.”

A plausible rejoinder would be that record-low real yields don’t exactly scream “robust growth,” but, depending on the circumstances, they can scream “buy stocks” or “pay more for a dollar of earnings” (recall the figure below).

In any event, you can draw your own conclusions. Morgan of course offered some projections for how high yields can go based on some careful math-ing, but I think that’s probably less relevant (because, let’s face it, Wall Street doesn’t often get it right when it comes to predicting the path of long-end US yields over long time horizons) than what the bank said about US fiscal policy and the seasonal.

The infrastructure package, which came into the new week on the brink of clearing the Senate hurdle, “would further support a push to higher yields,” Morgan said. When it comes to August seasonality, the bank remarked that “when yields are at their local lows heading into August, seasonality seldom works.”