2023-11-15 07:00:00
The scale of the debt market’s reaction to October’s understatement of U.S. inflation partly reflects outright relief from what is now one of the bond market’s biggest bets of the century.
Although annual consumer price inflation rates were only 0.1 percentage points lower than expected, at 3.2% and 4.0% respectively, this was enough to revive the story of disinflation, cementing the Federal Reserve’s top rates and adding a quarter-point rate cut to the 2024 futures curve.
As inflation expectations dwindled and gas prices fell nearly 20% in two months, economists were quick to point out that falling housing costs and property prices also meant that the core CPI was now below 2.8% annualized over five months.
“Pristine disinflation continues,” said Ronald Temple, chief strategist at Lazard. “In the absence of exogenous shocks, it is increasingly likely that the Fed will be able to cut rates in the second quarter of 2024.”
The recently booming bond market swallowed all of this.
Spurred by the announcement just before the release that Congress was prepared to avert a long-feared government shutdown later in the week, two-year Treasury yields fell 20 basis points – the sharpest decline in one day for almost four months – and 10-year yields fell to their lowest level in seven weeks, at 4.43%. This represents a drop of almost 60 basis points from 16-year highs reached just over 5% on October 23.
Earlier today, Bank of America’s influential Global Funds Survey found that more asset managers believe high bond yields offering the best rates in more than a decade are now a good business, despite three years of capital losses.
Returning to an era now famous in literature for “The Big Short”, the survey showed that global funds had accumulated their largest overweighting in bonds since the followingmath of the banking crash 15 years ago. Nearly two-thirds of respondents now think yields will be lower a year from now – a record in the survey’s 20-year history – and 80% expect lower short-term rates – a record since 2008.
In November, the funds’ bond allocation climbed 18 points during the month to a net overweight of 19%, nearly 3 standard deviations above long-term averages. Only the months of March 2009 and December 2008 showed greater bond overweightings.
However, BofA’s survey also recorded a first overweighting of global stocks since April 2022, perhaps reflecting the fact that many view 2024 as the year of 60/40 asset funds and bonds, given that a bond boom also lowers long-term borrowing costs, relieves indebted companies and flattens stock valuations.
And the S&P500 soared following Tuesday’s inflation report and falling bond yields, outpacing intraday gains by more than 2% for the first time since June.
“This report does not announce the end of inflation, but is a definitive indicator in that direction,” said Florian Ielpo of Lombard Odier. It is “favorable to equities, credit and duration, notably reducing the risk that the markets feared most: excessive tightening”.
SAFETY MARGIN
While doubling long-term bond allocations isn’t exactly a leveraged bet regarding to hit the jackpot, some elements of this scenario might trigger speculative squeezes of sorts.
Asset managers’ overweighting of bonds – or at least government bonds and U.S. Treasuries – tends to be reflected in large short positions in Treasury futures among hedge funds.
There are many reasons for this, one being that asset managers tend to build bond positions through futures before stocking up on cash bonds later and Hedge funds on the other side of this trade use short futures contracts to arbitrage anomalies between spot prices and futures prices.
The CFTC figures show the extent of this speculative “Big Short”, compared to the growing “Big Long” of ordinary asset managers. And days of positive inflation surprises, like this Tuesday, might well cause exceptional movements in Treasury bonds that reflect a certain run on these short positions.
Either way, the regular investing world seems happier than ever to invest in bonds, even following the 20%-plus losses suffered by benchmark Treasury exchange-traded funds in just over of three years.
Highlighting the high yields of corporate, emerging market and even “safe” Western government bonds, Duncan Lamont, a strategist at Schroders, points to the additional “margin of safety” that bonds now offer, i.e. that is, the extent of the increase in yields that can be absorbed over a 12-month horizon before investors lose money due to the capital impact of the offsetting fall in prices.
Mr. Lamont points out that yields on U.S. Treasury and investment-grade corporate bonds would need to rise by regarding another 100 basis points for capital losses to wipe out current yields. In addition, high-yield speculative securities can absorb an increase of up to 2.4 percentage points and emerging market debt 1.5 points.
“This does not eliminate risk, but adds a greater security blanket than has been provided in years,” he writes.
Everything is unlikely to go smoothly from here on out and disinflation may not always be so “immaculate”. Even if it continues at a sustained pace, the Fed seems determined not to allow the markets to relax their lending activity too quickly.
“History is full of examples of inflation followingshocks when central banks prematurely declare victory, cut rates too quickly and create the conditions for another spike in inflation,” says Jason Pride, strategist at Glenmede. “The Fed will likely be aware of this risk and keep rates higher for longer to avoid such an outcome.
But judging by bond investors’ growing confidence, the assumption is that the Fed’s optimism is now just a rearguard battle and more days like this are ahead.
The opinions expressed here are those of the author, a columnist for Archyde.com.
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