Treasuries Are Still Insurance From a Stock Market Meltdown

(Bloomberg Opinion) -- Just a few weeks ago, investors couldn’t seem to understand what was happening in the $15.4 trillion U.S. Treasury market. Long considered a safe haven, U.S. government securities were barely reacting to a bout of turbulence in equities. Stocks and bonds were both losers — how could that be?

This angst was perhaps captured best in a Nov. 14 headline from Barron’s: “Treasuries Won’t Protect Your Portfolio From This Stock Market.” It began:

“Bad news used to be good news for the U.S. Treasury market, lifting prices higher and pushing yields lower. No more.

First, falling stocks have consistently failed to provide a boost to Treasuries, even the most recent swoon that sent the Dow Jones Industrial Average sliding 600 points Monday. Now, even a record slide in crude oil prices can’t seem to help the longer end of the Treasury market, with yields declining only grudgingly.”

Fast forward three weeks and that thesis no longer holds water: A flurry of worrisome developments has sent investors to Treasuries in droves. As the S&P 500 plunged more than 3 percent on Tuesday, 10-year yields fell as much as 9 basis points, blasting through the 3 percent level to a three-month low. Thirty-year bond yields tumbled as much as 12 basis points, one of the biggest moves in recent memory. The swaps market began to price in Federal Reserve interest-rate cuts in 2020.

In other words, Treasuries were precisely the insurance policy that they have always been. It just took an overload of negative news to convince traders that they needed it. Consider only the geopolitical risks from the past two days:

  • President Donald Trump bragged about a victory on trade talk with China, but the markets looked through that bluster to the more subdued reality. He also called himself a “Tariff Man.”
  • U.K. Prime Minister Theresa May’s government was found in contempt of Parliament, a moment without precedent in recent history.
  • A U.S. senator called the evidence that Saudi Crown Prince Mohammed bin Salman played a role in dissident columnist Jamal Khashoggi’s dismemberment “a smoking saw.”
  • NATO foreign ministers concluded that Russia is violating a 1987 treaty on nuclear weapons with the U.S.

In terms of market indicators, parts of the U.S. yield curve inverted for the first time in more than a decade. As I wrote on Monday, this doesn’t necessarily mean a recession is upon us, but it does raise doubts about the sustainability of this economic cycle and the Fed’s ability to continue raising rates. One problem: Neither of those seem to be a concern to New York Fed President John Williams. Here’s what Bloomberg News’s Jeanna Smialek took away from the influential policy maker’s Tuesday press briefing:

“Williams gave an optimistic review of the U.S. economy, reiterated his support for further gradual interest-rate increases and expressed no concern that market participants have dialed back expectations for policy tightening in 2019.”

Simply put, that stands in sharp contrast to how bond traders interpreted Chairman Jerome Powell’s remarks last week that the Fed was “just below” neutral. No one, not even central bankers, really knows the neutral rate. So if Williams wants to keep going at the same pace as before, policy could quickly become restrictive and choke off growth, which supports purchases of longer-dated Treasuries. 

But perhaps the biggest shift taking place in the Treasury market this week is more technical in nature — a long-awaited “short squeeze.” Hedge funds and other large speculators have bet on higher U.S. 10-year yields for almost a full year now, building their net short position to an unprecedented level in late September. They’ve been gradually paring that back for weeks, but a full-blown capitulation is reminiscent of March and April 2017. From peak to trough, 10-year yields fell 46 basis points over that period. They’ve fallen 38 basis points at most since Oct. 9. 

Without those persistent bears lurking in the market, traders probably feel more comfortable with Treasuries as a hedge against big stock sell-offs. It certainly feels as if large funds are shifting out of equities and into long-duration securities to insulate their portfolios as year-end approaches, Bloomberg News’s Edward Bolingbroke wrote on Monday. And why not, with the S&P 500 barely up during a year in which risky assets were supposed to get a boost from U.S. tax cuts? It doesn’t help that Bank of America Merrill Lynch is now predicting a “baby bear” market coming soon for stocks.

All this serves as a reminder that market sentiment is always subject to sudden change, in both directions. If a U.S.-China trade deal emerges, many of the moves this week could very well reverse. Speculators could build up new short positions in Treasuries and the unusual relationship flagged by Barron’s could prevail once more.

But if these past couple of days proved anything, it’s that Treasuries still act like stock-market insurance when things get rough. As always, the question for traders is if the latest moves are a blip, or the start of something bigger. At least for now, they seem to be taking no chances.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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