Explaining 2022’s Burgeoning Bond Bear

By Tuesday afternoon in the US, “Treasury selloff” had replaced “stock rally” in headlines documenting the earliest price action of 2022.

At the risk of stating the obvious, it’s far too early to draw any conclusions about which macro narratives or themes will define the new year. In that context, there’s no “explaining” why yields were sharply higher as the calendar flipped. We can make a list of key factors (see below), but no one knew anything this week they didn’t know last week.

We know inflation is likely to get worse before it gets better, and there’s a solid case to be made that Omicron could be inflationary to the extent it exacerbates supply chain disruptions and/or prolongs labor market frictions. Data out Tuesday suggested the US manufacturing sector began to normalize in December. But a separate set of numbers showed a record number of Americans quit a job the prior month. I guess you could call that a “mixed bag,” but I’d be more inclined to quote the magic 8-ball: “Reply hazy, try again.” Or “Cannot predict now.” Or, “Better not tell you.”

Generally speaking, you can argue investors are looking past Omicron to Fed hikes and a continuation of the recovery, but that’s a flimsy excuse for what ended up being a ~15bps rise in 10-year yields over the first two days of the new year (figure below).

30-year yields breached 2% and two-year yields touched the highest since March of 2020.

Market participants were quick to extrapolate for the entire year — from two days. Some traders’ outlook “raises the prospect of negative Treasury returns for two consecutive years, a performance that would be unprecedented since records began in 1974,” Bloomberg’s Michael Mackenzie and Edward Bolingbroke wrote. (I realize you’re just documenting other people’s views, but it’s January 4, gentlemen. And it was January 3 when you wrote that. January 2 was a Sunday. January 1 a Saturday. Catch my drift?)

With US COVID cases topping 1 million in a single day and school closures piling up, you could just as easily describe the Treasury selloff as counterintuitive. Especially when placed in the context of a recalcitrant Joe Manchin, who on Tuesday said he’s not currently negotiating with The White House on the spending plan he torpedoed last month. In remarks to reporters, Manchin said he never says no to dialogue, but added that Democrats “don’t have the votes… to do some of the things that have been proposed.” He should know. He’s the vote they don’t have.

The point is, Build Back Better is still on life support, and it’s possible scores more Americans will be too over the coming weeks. Omicron causes less severe disease, but the sheer number of cases pretty clearly suggests hospitals will be inundated, even if a larger percentage of admissions are ultimately discharged to their homes rather than to the morgue. None of that screams higher Treasury yields. I’m not suggesting yields won’t be higher 12 months from now. But what I am suggesting is… well, see the magic 8-ball responses.

All of that said, it’s possible to list the contributing factors to the jump in yields. Nomura’s Charlie McElligott, citing colleague Darren Shames, did just that. Here’s the list (from a Tuesday note):

• Inflation “stuck” and currently unrelenting at multi-decade highs, with more Omicron supply chain snarls further squeezing prices
• Still above multi-year trend growth in the US (Atlanta Fed GDPNow @ 7.641% last)
• US Employment pushing “near full” again (4.2% U-Rate back to levels last seen pre-COVID)
• Imminent (obvious) Fed tapering commencement, but now, with actual balance sheet runoff (QT) potential thereafter in UST and MBS being socialized by some Fed members, all of which would mean the need for actual (gasp) price discovery for “private side” buyers, including convexity hedgers in Mortgages
• Start-of-year resumption of heavy Corp debt issuance calendar @ ~ $11.25B of paper (Street expectations of ~$140B for the full-month of January), with a particularly duration-heavy (> 10 years) WAM seen in [Monday’s] paper
• And with that of course, we have seen the shift to the market not just pricing-in three full FOMC hikes this year, but pulling the liftoff forward almost every day, with the March meeting now ~72% priced

So, again, that’s your checklist. And it does help explain duration sales in cash and futures on Monday and what McElligott described as “particularly aggressive” option flow.

Note TLT bled $1.2 billion to start the year, a gargantuan outflow amid the worst day for the product in a long, long time (figure below).

I trimmed the swings seen during March of 2020 so you can better visualize the scope of Monday’s selloff.

I suppose I’d be remiss not to mention, in passing, that the prospect of 10-year US yields at 2.75% made Byron Wien’s annual “surprises” list. In an interview with CNBC Tuesday, he reiterated the point.

Honestly, I wouldn’t be “surprised” (at all) to see 10-year yields at 2.75% at some point in 2022, nor would I be particularly taken aback to see them at 0.75%. We’re (basically) equidistant.

As ever, BMO’s Ian Lyngen and Ben Jeffery delivered an incisive assessment. The bond selloff on Monday and Tuesday “was consistent with the establishment of fresh short positions as 2022 gets underway,” they wrote, adding that “while not all net spec shorts were covered as last year came to a close, enough risk was taken off the table to imply setting up positions for the coming weeks/months would be the first order of business in the new year.”

In the same note, Lyngen and Jeffery said they’re “skeptical” that process is complete and suggested a retest of the 1.704% peak on 10s from October wouldn’t be surprising in and around December’s jobs report. “After all,” they wrote, “if the magnitude of COVID cases already realized isn’t sufficient to trigger a material risk-off sentiment, then it appears to be more a function of timing than outright levels.”

The market likely knew holiday festivities would give rise to a surge in cases considering the transmissibility of the Omicron variant. Those expectations muted the impact of the huge surge logged in the aftermath of New Year’s celebrations. What matters now is whether caseloads peak later this month, in line with expectations.

Finally, I’d note that the 40-year bond bull market technically came to an end in March of last year, when The Bloomberg Barclays US Long Treasury Total Return Index fell into a bear market (figure below).

The drawdown was ~22%, the worst ever.

It’s never been clear whether that “counted,” though. You won’t find too many people willing to say, with anything like conviction, that the decades-old bond bull in fact perished in Q1 2021.

Recalling that episode in a separate note out Tuesday afternoon, BMO’s Lyngen wrote that the “Q1 2021 pattern of a series of distinct bearish episodes followed by consolidations led to the step-up character of the last aggressive attempt to establish a higher yield plateau.”

For now, BMO said they’re “onboard with the march higher” in yields, albeit with a polite “nod” to the notion that the market chances “a give-back in the event rates falter on the path of 10s to 1.704% before challenging 1.77%.”