Bond market is overplaying the risk of a deep recession
Explaining the divide has become a Wall Street obsession – an urgent one, given the sway Treasuries hold in models designed to divine the future of inflation and Federal Reserve policy. One concern is whether things having nothing to do with the economy — bearish positioning among speculators, specifically – made the big drop in yields a recessionary false alarm.
“Each day that there isn’t a banking crisis is another day indicating that the current pricing doesn’t make sense, but it’s going to take a while,” said Bob Elliott, chief investment officer of Unlimited Funds, who worked for Bridgewater Associates for 13 years.
As usual in markets, the debate is far from settled, and the lurch in yields may end up being what it usually is: a grim signal for the future of the economy. While an oasis of calm at present, stocks themselves are a long way from sounding an all-clear. Their big declines last year, and the dominance of megacap technology shares atop the 2023 leader board, can be viewed as portents of trouble. Similar wrinkles exist in corporate credit.
Still, the gap in market reactions to March’s events continues to border on the historic. The stock market, usually an arena for shoot-first speculators whose grasp of big-picture meanings can be tenuous, absorbed Silicon Valley Bank’s (SVB) downfall and the contagion fears that followed with relative ease. In credit, blue-chip and high-yield spreads never got wider than levels seen last fall.
“The Treasury market isn’t trading every moment in pure fear mode, but that doesn’t mean that what’s currently in the price is some sort of prescient, ‘This is how to think about it’ signal,” said Pearkes, the firm’s global macro strategist. “Rates are way too low. We haven’t seen signs of a broader metastasising into credit markets, into the broader banking sector, of the deposit flight story, other than a few regional banks.”
Phrased differently: “The bond market has gone berserk,” said Dominique Dwor-Frecaut, a senior market strategist at research firm Macro Hive, who previously worked in the New York Fed’s markets group. “For once, I’m on the side of equity markets. I don’t see a recession coming.”
Meanwhile, the US$24 trillion Treasury market’s set-up in early March left bond traders vulnerable. Citigroup models and Commodity Futures Trading Commission data show that bets against two-year Treasuries had climbed to record levels ahead of the sudden collapse of SVB, thrashing hedge funds and speculators as markets dramatically recalibrated Fed expectations.
Of course, less than a month out from the failure of three banks and the government-sponsored bailout of a fourth in Europe, it’s too early for optimism, even as Treasury Secretary Janet Yellen said the system is showing signs of stabilisation. Harley Bassman, the former Merrill managing director who created the MOVE index in 1994, said it’s not unusual for the VIX – the equity volatility benchmark – and the MOVE to flash different signals, but history shows it doesn’t last.
“It’s just a matter of time until the VIX picks up,” said Bassman, who’s a managing partner at Simplify Asset Management. “Over the past 30 years, we’ve seen large correlation between the shape of the yield curve, credit spreads and implied volatility – and I mean all the volatility measures including the VIX and MOVE. The whole pack of the risk metrics are very correlated over the long term.”
“The market is extremely illiquid. What this reminds me of is the 2008-09 illiquidity in the bond markets. It’s kind of similar. You cannot afford to get stuck with a bad position,” said Vineer Bhansali, founder of LongTail Alpha and the former head of analytics for portfolio management at Pacific Investment Management. “The Treasury market is a roach motel right now. You can get in but you can’t get out. So be very careful.”
But after such a violent flush-out, the question becomes which managers are willing to step in and short the bond market again. In fact, investors have flocked to the opposite side of that trade: data from Citi shows that speculators have largely covered their shorts on front-end bonds, while positioning has flipped into bullish territory on some parts of the curve.
“The macro funds that were positioned for higher-for-longer are unlikely to start leveraging back up, regardless of what the pricing is. They just got burned by it,” Elliott said.
“The folks that were previously short the two-year, it’s going to take a series of data points to get confident enough to start selling those positions again.” BLOOMBERG
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