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Bond Trading Is Only for the Brave in This Shock Rally

Bond Trading Is Only for the Brave in This Shock Rally

(Bloomberg Opinion) -- It’s bad enough writing about another steep plunge in bond yields across the globe and prognosticating about the market’s next move. It’s almost certainly worse to be putting money on the line.

Just some things to consider: The benchmark 10-year Treasury yield fell to as low as 2.35 percent, a level unseen since 2017, from 2.62 percent just a week ago. Yields on two-year notes, which drew strong demand at a $40 billion auction on Tuesday, reached 2.16 percent as more than one full rate cut from the Federal Reserve is priced in by the end of the year. Elsewhere, Germany sold 10-year bunds with a negative yield for the first time since 2016, while New Zealand 10-year yields tumbled by 11 basis points after its central bank said its next move is more likely to be a cut.

Bond Trading Is Only for the Brave in This Shock Rally

If you believe that the world economy is on the verge of a significant slowdown, then sure, the trading decision is easy: Load up on haven assets like Treasuries and bunds, even if yields are the lowest in years. There is certainly enough data to justify such concerns, from the big slump in Germany’s purchasing managers’ index last week to weakening confidence among U.S. consumers and chief executives. Broadly, Citigroup Inc.’s global economic surprise index fell earlier this month to the lowest level since 2013, and it has barely rebounded.

Investors may also be reverting to their playbook of not fighting the central banks’ dovish turn. After all, the alternative is wading through a mess of headlines. Who wants to handicap the odds of various Brexit scenarios? Or grapple with Turkey engineering a currency crunch? Or wondering whether Stephen Moore, whom Donald Trump is expected to nominate for a Fed seat, is serious when he says the central bank should immediately lower interest rates by 50 basis points?

Bond Trading Is Only for the Brave in This Shock Rally

At the same time, it’s hard to shake the feeling that a lot of what’s happening is a rapid repricing that’s more technical in nature. Case in point: a Bloomberg News article titled “Here’s Why U.S. Bond Yields Plunged So Much Over the Past Week.” You won’t find the words “recession,” “slowdown” or “growth” anywhere. Instead, this is the key takeaway:

The Federal Reserve’s surprise policy shift last week shook markets, but, even still, the intensity of the ensuing drop in U.S. bond yields has puzzled many observers. A massive wave of hedging in the swaps market helps explain the scale of the eye-catching move.

Treasuries rallied after the Fed signaled it was done raising interest rates for the moment, driving yields on 10-year notes down to levels last seen in 2017. That forced two sets of traders — those who had bought mortgage bonds and those who had bet markets would remain calm — to turn to derivatives markets to tweak their portfolios or stanch their losses. They snapped up positions in interest-rate swaps, pushing Treasury yields down even more.

On top of it all, fund managers are fast approaching the end of the month and the quarter, which is usually a time for rebalancing portfolios. In Japan, March 31 is the end of the fiscal year, and Treasury holdings in the country have increased three consecutive months through January, the longest stretch since early 2017. Japanese investors historically tend to buy in March and then sell in April.

Put it all together, and it’s no surprise that traders are “feeling a bit run over,” in the words of Bloomberg News’s Cameron Crise. “Every time that I think that the U.S. bond market can’t rally much more, yields take another leg lower,” he wrote.

You have to be brave to trade “macro” right now, given just how abruptly global central banks have changed their tune. After all, Fed Chairman Jerome Powell went from saying that U.S. interest rates were a “long way” from neutral and that the balance sheet runoff was on “automatic pilot” to halting further rate increases and specifying the end of tapering in just a matter of months. It seems unlikely that he or his colleagues will flip back to hawkish. It’s easier to imagine them turning extra-dovish in the face of continued economic uncertainty. 

At the risk of getting trampled again, the most likely path forward is yields hovering around their current levels rather than dropping more. As mundane as it may seem, I buy the argument that “mortgage convexity receiving hedging” from money managers and real-estate investment trusts sparked a duration grab. And it seemed pretty clear just two weeks ago that traders were bracing for a range-bound bond market, so it follows that those who got caught selling volatility had to hedge by effectively going long Treasuries. Nothing gets a market moving quite like a short squeeze.

Bond Trading Is Only for the Brave in This Shock Rally

Technical analysis signals that 10-year Treasury yields are bumping up against key levels of 2.37 percent and 2.29 percent. Relative-strength indexes show the 10-year note is overbought. Intuitively, the current fair value of the global borrowing benchmark should be close to 2.5 percent, or the top of the fed funds target range, if Powell’s comments are to be believed that the next rate move could be up or down.

It’s one thing to argue that the bond rally is about done for now. Actually betting on that view, though? That’s an entirely different matter, especially considering that the S&P 500 Index isn’t too far off its record high. If stock investors decide the party’s really over this time, Treasuries will surely extend gains. Indeed, as equities slid on Wednesday, 10-year yields approached new lows, further inverting the yield curve.

After a boring, range-bound start to 2019, it’s no doubt painful to see the highest yield levels in years disappear in what feels like an instant. But as volatility returns, it could be even more perilous for investors to assume they know what will happen next in the world’s biggest bond market.

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net

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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