Head of Fixed Income Strategy
Summary: Yesterday's volatility in the bond market strengthens our belief that central banks' intervention is needed again to avoid another crisis. In the United States, the move up in yields has just started to tighten economic conditions. This week the correlation between Treasury yields and junk bond performance has turned negative, signalling that the selloff might soon leak to risky assets. In Europe, the periphery might soon face problems refinancing its debt as demand for bonds suddenly drops.
Why the Federal Reserve should step in:
Yesterday we saw an incredible move up of US Treasury yields. Ten-year yields went up as much as 1.61% following a weak 7-year auction that saw a high drop in foreign demand in US Treasuries. This is very worrying because the Treasury will need to continue to issue more Treasuries to finance Biden's $1.9 trillion stimulus package, leaving the market wondering whether demand will be able to match the supply? If it doesn't, we might see an acceleration of the selloff in Treasuries that will lead to other meaningful squeezes such as the convexity hedging that we saw yesterday, which ultimately triggered a set of events that led to the spike of US Treasury yields spiking.
1. Real interest rates are on the rise, and financial conditions are about to tighten
Yesterday selloff hit the whole US yield curve. 2 year Treasury yields rose sharply by 5 basis points, the highest since March last year when we were in the middle of the Covid pandemic. Alarmingly though, the spike in yields didn't match a rise in inflation expectation. Actually, the 2-year Breakeven rate has fallen since the mid-February peak.
It is very troubling for the Federal reserve to see a rise in real interest rates because it leads to a rise in the cost of capital for corporations, putting pressure on overleveraged zombies. The move up in real rates has been substantial in the past few weeks. We saw 10-year TIPS at -1% in mid-February, going to -0.65% in a matter of days. At the same time, the yield on 30- year TIPS has gone back to positive territory. Unfortunately, this has led to a slight tightening of economic conditions, which could become more pronounced as real rates continue to rise.
2. Correlation between yields and junk has turned negative from this week, pointing to a bigger selloff ahead
It is about to become a challenging market for risky assets. While junk bonds have benefited from a strong risk appetite since the beginning of the year, we may be about to see the tide turning. This week indeed had seen the correlation between Treasury yields and Junk bond returns turning negative, exactly as it happened during the 2013 Taper Tantrum when yields were rising, pointing to the fact that it may just be starting to get uncomfortable for risky assets. To learn more about this click here.
Reasons why the European Central Bank should step in:
1. The periphery is just about to get into troubles
The ECB's monetary policies were doing well until the reflation trade in US Treasuries provoked a spike in European yields. Although many European sovereigns yields are still trading at historic low levels, one cannot ignore other important signals. Yesterday's Italy 5 year BTP auction was exceptionally weak, registering the lowest bid-to-cover ratio since June. At the same time, Greeks government bonds fell by more than 3% in just a month. This is about to bring back reminisces from the periphery crisis, which cannot happen while there is no clear path to recovery, and the economy lacks fiscal stimulus.
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