Weekly Perspective: For Whom the Bell Tolls

Forty years and 4,562%. That is how long and how far the bull market in bonds has charged, until now. The Bloomberg Barclay’s Treasury Total Return Index has just sustained its first 20% drawdown, what is often considered the threshold of a “bear market”, during its spectacular 40-year run (see Chart 1).

Before we start ringing the skillet bell on the bond bull market, let’s take a look at this sell-off in bonds to see if it is, in fact, an end of an era, or if the long-term trend of lower yields remains intact.

Chart 1: Bloomberg Barclay’s Treasury Total Return Index with Maximum Drawdown (bottom panel)

^{Source: Bloomberg, Fieldpoint Private}

The degree of the recent rebound in yields (sell-off in price) is so large because the starting point for yields was so low. Chart 2 shows how unprecedented the collapse in yields was in the early days of the pandemic. Chart 3 shows how rapid this move higher in yields has been: this has been the largest six-month change in 10-year yields in the past 60 years. Note the increasing magnitude of these moves over the past ten years. Is this a function of massive central bank intervention since the GFC and similar to the increasing intensity of boom/bust cycles we observe in other asset classes?

Chart 2: U.S. Treasury 10-Year Yield (60 year, weekly, log scale)
Note the magnitude of the collapse in 2020

^{Source: Bloomberg, Fieldpoint Private}

Chart 3: 6-Month Change in U.S. Treasury 10-Year Yield
The largest 6-month move in 60 years note the increasing magnitude over the last 10 years

^{Source: Bloomberg, Fieldpoint Private}

Hitting an all-time low of 0.51% on August 4, 2020, a 75% drop over the prior six months, created plenty of room for upside to yields, while still remaining in the long-term downtrend. Chart 4 shows how the recent move higher in yields only brings us back to the territory of prior all-time lows (2012 and 2016), with still room for upside while retaining the long-term downtrend in yields that have characterized the 40-year bull market in bonds.

It is interesting to note in this chart that the inflationary period of value-led, pro-cyclical, non-US dominant, commodity boom markets of 2003-2007 happened with a tailwind of higher rates that still remained within the confines of this long term downtrend in yields.

Chart 4: U.S. Treasury 10-Year Yield (30 Year, monthly)
Despite the sharp move higher, yields are still only near the 2012/2016 lows; plenty of room for yields to move higher and remain in a long term downtrend

Outside of price action, what about fundamental factors that could drive a shift in the long-term return potential for bonds? We have written about the policy regime change (see article here), where the combination of aggressive, deficit-fueled fiscal spending plus inflation-tolerant monetary policy has the potential to cause a shift in leadership away from assets that thrived in the prior regime (which was characterized by low reliance on fiscal spending and a Fed inclined to tighten at the first early sign of inflation).

The key question for long bonds continues to be about inflation, as higher inflation would make the relatively low yields on long bonds increasingly unattractive. But there remains a vigorous debate about just how inflationary this policy shift will be (see our article here, plus this video of Bloomberg’s Wall Street Week starting at minute 24 that includes interviews on both sides of the debate with Paul Krugman and Larry Summers). To see a true end to the long-term bull market in bonds, we would likely need to see a sustained period of higher, possibly runaway inflation that is either shrugged off by the Fed or impervious to the Fed’s efforts to eventually control it.

It is likely too early to make this call. We know inflation will be high in the coming months due to base effects (easy comparisons from 2020), the stimulus being released on the reopening economy, and tight/disrupted supply chains. It is possible that these inflation impacts last somewhat longer than the inflation-doubters expect say into 2022, mainly due to supply chain constraints. This could be the cause of further upward pressure on yields in the near term. However, this doesn’t automatically mean that we find ourselves in an entrenched inflationary environment similar to the late 1960s through the early 1980s. As Steve Ricchiuto clearly lays out in his accessible and enlightening Disequilibrium, the conditions that eventually broke the Great Inflation are still present today (globalization, demographics, technology, lower regulation, lower labor bargaining power, etc.). Thus, here is the key question: will the shift to a more inflationary policy regime be enough to overwhelm these more stable disinflationary economic drivers?

So, similar to price action, we find ourselves witnessing an extraordinary change while remaining at an ambiguous juncture. It is too early to call the end of the long downtrend in bond yields from both a technical and fundamental perspective, while it is likely also too early to call an end to the current volatility we are experiencing in bond yields. The reality is that the U.S. economy is about to experience its fastest GDP growth in almost 40 years (the Fed raised its 2021 growth estimate to 6.5%), with an unemployment rate expected to move back close to a 50 year low by the end of the year, fueled by an unprecedented amount of fiscal and monetary policy support, all the while long bond yields, even after the recent move higher, are still very low from a historical perspective. Further rationalization of yields and growth/inflation/employment levels can be expected.

And here we find ourselves, quite like Robert Jordan at the end of the Hemingway novel asserting: “There’s no one thing that’s true. It’s all true.”

Last Week in Markets: Choppy Equities Still End At Records; Long Yields Higher While ECB Promises to Step Up Buying

Equities

U.S. large-cap equity indices ended the week lower (S&P 500 -0.77%, NASDAQ -0.79%, Dow Jones Industrial -0.46%). After a particularly strong prior week, small caps underperformed last week (Russell 2000 -2.77%). Growth and Value were both down and by similar amounts (Growth -0.88%, Value -0.83%).

From a sector perspective, as seen in Table 1 below, defensive sectors (Staples, Health Care and Utilities) were amongst the best performers. After a strong start to the week, enjoying the steepening of the yield curve, Financials came under pressure on Friday after the Fed announced it would not be extending the yearlong easing of capital requirements for large banks (see WSJ here). Though there was some continued volatility in the Treasury market on Friday, large Treasury market disruption is not expected given a more permanent solution to capital relief is likely given the continued surge in both Treasury issuance and deposits (see WSJ article here). Energy shares also came under pressure due to the drop in oil prices, which analysts attributed to a combination of higher U.S. oil inventories and the faltering recovery in Europe given renewed lockdowns. See the commodity section below for a further discussion about oil prices.

Table 1: S&P 500 Sector Performance

Index Name	1 Week	YTD
Consumer Discretionary	-0.1%	2.0%
Consumer Staples	0.5%	-2.7%
Communication Services	0.2%	8.5%
Energy	-7.7%	29.3%
Financials	-1.7%	15.5%
Health Care	0.4%	1.0%
Industrials	-0.3%	8.6%
Materials	-0.8%	7.2%
Tech	-1.4%	-0.8%
Utilities	-0.3%	-1.6%
Real Estates	-1.0%	5.2%
S&P 500	-0.8%	4.2%

^{Source: Bloomberg, Fieldpoint Private, as of 3/12/21}

Currencies and Commodities

As mentioned earlier, oil prices came under pressure last week (WTI -6.73% to $60.99, Brent -6.91% to $64.12). Analysts ascribed the weakness to a report of an increase in U.S. oil inventories, worries about the demand recovery in Europe due to renewed lockdowns, and rationalizations that oil prices had likely moved too far too fast. Adding to this, the International Energy Agency released its Oil Market Report, where it threw cold water on the notion that oil has entered into a new super-cycle and there is an impending supply shortfall (see IEA report here). The IEA argues that there remains a substantial inventory overhang and significant spare production capacity that will serve to limit oil’s ability to sustain significant price increases (see Bloomberg article here for further perspective: “But you don’t hold that much spare capacity when things are going great; this is not the stuff of supercycles”;). In the U.S., O&G producers are striking a balance between growing production to capitalize on higher prices and keeping shareholders happy by fixing balance sheets and “living” within their cash flows (this FT article).

Chart 5: U.S. Crude Production is Expected to Rise Again

^{Source: Bloomberg, Fieldpoint Private}

 

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