The “time is coming to position for the long duration trade.”
So said JPMorgan analysts led by Mislav Matejka on Monday.
While not exactly a groundbreaking observation, Matejka’s contention that bonds are probably oversold was nevertheless worth mentioning for the extent to which it added to a growing chorus of calls for a bullish reversal following a two-month escalation which pushed 30-year US yields to 5% and found the term premium climbing rapidly into positive territory.
The summer selloff “was initially driven by the more favorable growth outlook, but more recently by the less supportive demand-supply balance for fixed income, as well as the adjustment to the higher-for-longer Fed,” Matejka remarked.
As the figure in the bottom pane (above) shows, 10-year US yields are the most oversold in three decades outside of the post-pandemic inflation context.
Of course, an oversold RSI doesn’t a rally make. Matejka’s broader point was that, as he put it, “rising bond yields at these levels are problematic for investor sentiment and for the economy, and are therefore ultimately not sustainable.”
I’m generally on board with that view, at least in the near-term. As I’ve endeavored to make clear in recent weeks, I do think yields will be structurally higher going forward, but that doesn’t preclude a rally in the face of bad news (economic or otherwise), nor does it necessarily mean that yields will sustain current levels in a “higher-for-longer” environment. We’re coming out of a regime where negative yields on safe haven government bonds were more norm than exception outside the US. Measured against that, any yield would count as “higher.”
The figure above speaks for itself. Yields tend to fall after the final Fed hike, and although JPMorgan “acknowledge[s] that the US fiscal deficit is significant, with a deteriorating supply-demand picture for government bonds,” the bank noted that yields are currently trading “above inflation forwards, and above levels of economic activity, with growth at risk of softening post the strong Q3 prints.”
As far as the impact of higher oil prices, Matejka wrote that while the crude rally “does mechanically imply that PPIs, as well as CPIs, could inflect higher again… unlike the 2021-2022 episode, where bond yields and oil were moving up together in order to reflect economies reopening, and where the consumer at the time was accepting of rising prices, the recent oil rally was mostly for supply reasons [which] could lead to demand destruction and be deflationary, rather than inflationary.”
Some readers will doubtlessly note that the Israel-Hamas war has the potential to push up crude prices, but I’d caution that it’s very difficult to say how much geopolitical premium is warranted in any given crisis. There’s no formula for that. Even in September of 2019, when Iran’s proxies in Yemen attacked Saudi oil infrastructure, it was hard to say what the “fair” price was for crude given uncertainty around when the lost supply would come back online, and so on. In addition to being unpredictable, the geopolitical premium can also prove ephemeral. Blink and you may miss the spike. The idea that anyone has a good read on what an Israeli incursion into Gaza might mean for oil (assuming it means anything) is dubious. Basing a forecast for bond yields on any such speculation is beyond futile.
As for whether lower bond yields would help stocks through the valuation channel, Matejka was cautious. “If bond yields roll over, will it help equity valuations?” he asked, before answering his own question: “Not if yields are peaking at the time when earnings, and the broader economy, start to disappoint.”
