A Famous Deflationist On What’s Next For Bonds

Remember when US Treasurys were on track for an unprecedented third consecutive annual decline?

I do. I remember that. It was just two months ago.

On October 19, when Jerome Powell told David Westin that US monetary policy wasn’t too tight, US government bonds were staring at a ~3% loss for 2023. That was atop 2022’s history-making 13% decline, which was itself a wholly unfortunate encore to 2021’s 2.5% loss.

We were that close to history. Two and a half months from a third year of losses for Treasurys.

Then, everything changed. Beginning in early November, the macro-policy environment shifted decisively in favor of bonds, as Treasury undershot expected coupon increases in the refunding announcement, the Fed laid the groundwork for this month’s dovish pivot and the US macro data came in softer-than-expected almost across the board.

The result was a rally for the ages, as long-end yields plunged more than 100bps from their late-October intraday peaks, trigging a wave of buy-to-cover flows across the managed futures space, where legacy shorts in bonds and STIRs were erased in a matter of six weeks.

It was a roller coaster to be sure. The figure above is a testament to that, as well as to the ferocity of the recent rally.

If the question is “What now?” the answer is “Who knows.” Not Wall Street, that’s for sure. And I don’t mean that pejoratively. It’s well nigh impossible to make accurate point forecasts for US Treasury yields in normal times. And on the off chance you haven’t noticed, these times of ours after the furthest thing from normal, unless you subscribe (as I generally do) to the notion that in fact, our belief that the past three or four decades constituted a “new normal” was a misguided delusion.

One person who knows a thing or two about bond rallies is SocGen’s Albert Edwards who, whatever else you want to say, was generally on the right side of the 40-year bond bull. In 2021, Edwards suggested his pseudo-famous “Ice Age” thesis was in the process of becoming a “Great Melt.” That prediction proved prescient.

Given the scope and rapidity of the almost two-month-old bond rally, I was interested to get Albert’s assessment on whether the bond bull is resurrected or whether the recent sharp decline in yields is merely a cyclical rally. He weighed in on Thursday, using remarks from David Rosenberg as a jumping-off point:

I’m not sure that the pundits or even market participants have a complete understanding or appreciation as to how far interest rates can go down from here now that the bond bear market has been broken. Whether the first cut is March or May, the die is cast and what matters most is the magnitude and duration of this renewed easing cycle that is now in full view. A 110bps plunge in the 10-year Treasury note yield serves as an exclamation mark in that regard. We have seen ten such declines from a peak over the past 40 years. And not once did the fresh bull market stop there. The average additional drop was -200bps; the median was – 170bps; the mode was -150bps. So historically speaking, it shouldn’t surprise anyone other than the bond permabears that we end up seeing the 10-year T-note yield slice below 2.5% before this thing runs out of gas.

Edwards concurs with Rosenberg. Sort of. “I absolutely agree [that] there is a lot further to go in this bond rally, and I think many investors may even start believing we are returning to the ‘Ice-Age’ interest rates that prevailed pre-pandemic,” he said Thursday. Then he added a caveat.

“They would be mistaken in my view,” Albert wrote, of anyone betting on a return to the frozen tundra. “I anticipate only a brief cyclical visit back to ultra-low yields.”

He pointed to a series of charts which together demonstrate that “some key elements of the Ice Age thesis have permanently broken.” Of the three charts he highlighted, the simple correlation figure below is perhaps the most germane for asset allocators.

I’ve been over this time and again, most recently late last month. The assumption that the negative stock-bond return correlation which persisted for two decades (give or take) would hold in perpetuity was predicated on well-behaved inflation. A bout of unstable prices always had the potential to end the four-decade bond bull. Central banks’ efforts to slay the inflation dragon could reset equity valuations, resulting in a simultaneous selloff — a positive stock-bond return correlation. That’s exactly what happened in 2022.

“One thing I remember highlighting in the late 1990s regarding the impending Ice Age was the inversion of the longstanding positive equity/bond correlation —  low inflation had reached the point that it would flip this correlation negative,” Edwards wrote Thursday. “It was a big call, but maybe the recent flip back to a positive correlation is telling us something similar, confirming that any steep fall in 10-year yields will be cyclical and brief.”

Although I’m still a bond bull for 2024, maybe I should rethink, particularly given how lucky I was to catch this particular falling knife uninjured in October. When it comes to the likely direction of yields, Edwards’s opinion is worth considering.