Cognitive Dissonance And The Bond Bears

If you’re the type who thinks it’s a contrarian indicator when seemingly everyone coalesces around some variation on the same general macro theme, it’s worth noting that, at least according to one survey, market participants have never been more pessimistic on bonds.

On several levels, that makes sense. Inflation is running the hottest in decades across multiple advanced economies and one way or another, central banks are in a position to facilitate higher rates, either with hikes aimed at reining in inflation or by acquiescing to price overshoots in an effort to foster full employment via policy accommodation.

Throw in large deficits and ambitious, progressive fiscal agendas, and the stage appears set for higher yields.

It’s thus no surprise that, as BofA’s Michael Hartnett highlighted Tuesday, global bond allocations “fell to the lowest level ever to a net -80%” in the bank’s latest fund manager survey “as expectations for higher rates continued to rise on the back of inflation fears.”

Along the same lines, inflation was the top tail risk in the poll for the eighth consecutive month (I’m including months when investors identified “bond tantrum” as the top risk).

Note that it wasn’t a close race in October. The number two tail risk was “China,” which garnered 23% versus more than double that (48%) for inflation.

For good measure, investors said inflation was likely to be the number one driver of asset markets next year. Tied with inflation on the list of 2022 market drivers was the Fed.

What’s difficult to reconcile (and this certainly isn’t the first time that the findings in BofA’s monthly fund manager survey suggest some cognitive dissonance among investors) is the dramatically bearish outlook for bonds and the suddenly dour outlook for the global economy.

Read more: $1.3 Trillion Is Now Least Bullish In A Year, Key Survey Shows

Not only did expectations for global growth turn negative for the first time in 18 months, but yield curve expectations collapsed too (see the linked article above).

The decline in the percentage expecting a steeper yield curve was mostly attributable to expectations for higher short-end rates (as central banks hike), but there’s something incongruous about all of this.

Investors are the most bearish bonds ever, and the least bullish on growth since the pandemic shock. Unless you’re completely convinced that stagflation is right around the corner (and who knows, maybe that’s becoming the consensus, if not officially, among analysts, then psychologically, among investors and consumers), those two views can’t coexist peacefully.

Stagflation expectations (as proxied by those who expect below-trend growth and above-trend inflation) did rise 14 points from the September survey, but also note that when asked to identify the most likely market outcomes as the Fed tapers, investors said a higher VIX and a stronger dollar (figure below).

It’s at least possible to argue that such an environment would be conducive to lower long-end yields, not higher.

Remember, Fed tapering can bring about counterintuitive price action. If the idea behind monthly bond-buying is to stimulate and otherwise reflate, then tapering is best conceptualized as the abatement of a stimulative, reflationary impulse, not as the removal of demand for the US long-end, which will always find sponsorship from someone, somewhere, especially in the event a hawkish Fed creates market volatility and stokes policy error fears.

In his latest, Deutsche Bank’s Aleksandar Kocic posited a “snap back” at the long-end following the recent flattening, but his description of the ambiguity was perhaps the most poignant passage.

“While it might not be difficult to have a relatively high conviction about the rates direction, such conviction is easily absent when it comes to the mode of curve reshaping,” Kocic wrote. “Even if one accepts that the recent curve twist contains a certain amount of policy mistake – the long end rebellion against near-term rate hikes – that message is largely distorted by the forces of foreign flows (and domestic short covering) not related to the actual repricing of the Fed and it is not clear how to decompose the two forces.”