Bond Market Fear and Loathing

The bond market has come unglued in the last few days.  This kind of bond volatility (to the downside) in a weakening economy must be taking out some leveraged players that we may hear about later.  As much as Treasury yields have moved recently, yields in Europe have been even more violent.  Treasuries have started pricing in the worst possible scenario for Fed tightening, and the massive losses in the past few days have infected the long end of the curve, as the short end led the selloff late last week, and this week, its been the long end taking the brunt of the punishment.  

Bond investors and stock investors are just different.  Those who buy bonds are conservative, and are looking to protect capital while collecting some yield.  They eschew risk, and are more easily unnerved when losses get big.  2022 has been a heart attack for bond investors, and I'm sure a lot of retired elderly parked out in bonds expecting their assets to be safe have gotten a rude awakening.  That's why you've had this big selloff when everyone realized that the Fed really has blinders on, hawkish blinders, raising rates relentlessly, economy be damned.  Bond investors have been taking more punishment than stock investors, as you can see by this chart:

Take a look at the 3 month performance of TLT, AAPL, and TSLA.  TSLA is up 19.7%, AAPL is up 6.7%, and TLT is down 9.6%.  

Stock investors have quite a different view of the current market than bond investors.  As much as I hear stock investors being bearish and pessimistic, they haven't sold much, while bond investors have been more quiet, but much more terrified of this market, selling down, as you can see in the fund flows for stock and bond funds.  

They are no longer piling into equity funds, like they did in 2021, but they haven't really sold much either. 

Based on relative valuations and the outflows that have already happened in bonds, I am getting quite bullish on the prospects for the bond market over the next 3-6 months.  At 10 year yields near 4%, you are turning the tables on the risk/reward for bonds vs stocks, making this the best time to be in bonds vs stocks since 2000.  I expect the inflation rate to be higher over the next 5 years than it was between 2000 and 2005, but the organic growth rate of the US is much lower than it was back then.  And the level of indebtedness is much greater now than back then, with a much more financialized economy that can't function well with higher rates.  So 4% in 2022 is akin to 6% in 2000.  

There is recency bias in the markets that has encouraged US stock investors to hold on when the markets go down, because it always goes back up.  Since the end of the bear market in 2009, deep losses in 2010, 2011, 2015/2016, 2018, and 2020 were all erased in less than 6 months, usually taking less than 3 months.  This has conditioned stock investors to just hang on and not sell, which has been the main reason they haven't budged despite sounding off about their bearishness in those sentiment surveys which have become nearly useless in 2022.  A bunch of fully invested bears.  2022 has been the first time in 13 years that you've actually had an established downtrend that has made lower lows and lower highs for more than 6 months. This is catching a lot of investors off-guard, way overexposed to risk parity, with not enough cash to buffer the volatility. 

Unlike stocks, there is not much of a recency bias in the bond market.  Bond investors are normally much more cautious and less sanguine about future bond returns.  They are just looking to get some yield while not risking too much money.  They don't expect ever higher prices and lower yields.  And with all the talk about inflation and how hawkish the central banks are, you are getting levels of pessimism that are quite extreme, and don't reflect the reality that leading indicators of inflation which are trending lower.  If you look at money supply growth and commodity markets, you can expect inflation to come down more than people expect in the first half of 2023.  That will coincide with the end of the Fed rate hiking cycle. Those are 2 potent bullish catalysts for bonds.  

The momentum is clearly bearish in the bond market, but the past few days since the FOMC meeting have been panicky selling, more than a big repricing of inflation or Fed rate hike expectations.  I am still holding a small bond position, while remaining short SPX/NDX.  Still see too many dip buyers who expect a short term rally, so rallies are likely to be quickly sold.  The fundamentals are much worse now than it was back in June at the same price levels.  And we are that much closer to the real economy entering a big slowdown.  

What the Bank of England did yesterday shows how much stress is accumulating from the plunging global bond markets.  Optimism from one off interventions are not bullish for stocks.  Only continuous interventions via QE programs can affect market pricing for the intermediate to long term.  Saving the market with these interventions without any change to their monetary policy will do nothing for the long term trajectory of the market.  They are just short squeeze events.  

More so than a strong dollar, a weak global bond market is more troublesome for stocks and the economy.  Until you see a strong sustained bounce in bonds, which doesn't look likely until at least the next CPI release, on October 13, stock rallies will be quickly sold as there will be nothing fundamental to latch on to for the bulls.  The bears are trading the fundamentals.  The bulls are trading the technicals (hoping for an oversold bounce).  

I think 4% 10 year yields should provide a short term floor for bonds, but there is so much damage going on in the bond market, bonds are trading like distressed assets.  There is potential for overshoots to the downside.  But once you get past the next couple of weeks, I think the sidelined buyers in fixed income will come back as the dust settles on the carnage, with good values left behind.