MON 28 MAR 2022
There is an old saying in the stock market that you should be buying when they’re crying and selling when they’re yelling. The observation is clearly a contrarian statement about extremes in sentiment, positioning and beliefs. Recent price action in the bond market has been impulsive, rapid and emotional. There has been a capitulation in the prevailing bias on the path of future short term interest rates which is a key component of fair value for the long bond. Indeed, the December 2022 Eurodollar contract is now trading at an implied yield of 2.86% which, as we noted last week, is not far from the consensus estimate of the neutral rate. We don’t know whether the Fed will end up delivering on that estimate. More likely, the Fed will hike (and reduce the balance sheet) until something breaks.
In the short term, the velocity of the rise in yields and the flattening of the curve has been breath-taking. The global bond index is now the most oversold relative to its underlying trend in the past 20 years (chart 1). It is also notable that fixed income as an asset class has materially underperformed equities over the past month and quarter in spite of the drawdown in equities. While that might cause traditional multi-asset managers to re-balance out of equities into bonds, it highlights the existential problem of the inability of bonds to diversify equities in the current episode.
Of course, the other important fair value component of the long bond is inflation or, more accurately, a risk premium for inflation expectations, liquidity and term to maturity. In spite of the magnitude and velocity of the recent move in the nominal 10 year yield, the real yield (nominal less breakeven inflation) is still -0.46% (chart 2). Put another way, the expected return on the nominal 10 year Treasury is still insufficient to compensate investors for inflation risk (the real yield is clearly even more negative based on current headline inflation).
Tactically, the picture is more complex. Inflation lags the growth cycle. If macro conditions slow over the coming months, perhaps reinforced by more aggressive Fed tightening of financial conditions, it is plausible that inflation expectations might be near a peak (front loaded policy tightening). That might be what aggressive flattening of the yield curve is signalling. However, the big picture point above on bond valuation is that inflation expectations would need to fall a lot to make fixed income attractive on a real or risk-adjusted basis. On the positive side, the velocity of the move has been so rapid, that the market could price it in relatively quickly.
The correlated question is why have equities still been so resilient from the recent low? To be fair, bear market rallies are not unusual. Moreover, considerably more weakness was priced into the most discount-rate sensitive sectors. However, it is important to note that inflation is an equity killer and is a key reason why peaks in the ratio of S&P500/commodities has flagged major cycle peaks in stocks. From a fundamental standpoint inflation clearly puts downward pressure on profit margins and drives central banks to tighten policy.
In conclusion, it is probably still too early to consider adding to fixed income, but the opportunity might present itself fairly quickly over the coming weeks or months. At the very least, most of the probable Fed tightening is likely priced.