Last week, U.S. bonds suffered a huge sell-off, with the 10-year U.S. bond yield once breaking 1.6%, a one-year high. Last Thursday, momentum traders shorted U.S. bonds on the largest scale since the 2013 tapering scare, Jefferies International data show.
Michael Hartnett of Bank of America said it was the second worst bear market in 40 years for the bond market.
He also noted that the bond sell-off (more than in 1994 and 1999, but not as bad as the 2013 “tapering panic”) could lead to panic contagion, illiquidity, corporate bankruptcies and many other problems. Volatility, Inflation hedging and currency devaluation will be hot topics in 2021.
The reasons for the spike in U.S. bond yields, as mentioned in last week’s article, will not be repeated here, summarizing the three main reasons: rising inflation expectations, the Fed’s lack of action and the possible after-market risk of “convex hedging”.
Now, people are more concerned about how the U.S. bond yields will develop this week, and whether the bond panic can be calmed? Here, we’ll sort it out.
Four Ways to Quell the “Bond Panic
Panigirtzoglou, an analyst at JPMorgan Chase, said that in order to quell the current bond market crisis and allow stocks and risk assets to resume their upward trend, two conditions must be met.
Bond yield volatility needs to decline from its current high levels.
Bond yields need to fall back, giving back some of the recent gains, especially in the 5-year U.S. bond yields.
He also said there are four ways to reach these two conditions.
One, the Fed intervenes, such as by accelerating the pace of bond purchases.
However, JPMorgan Chase believes that the Fed is unlikely to take such action yet, judging from the current market pressure.
JPMorgan notes that while market depth indicators for U.S. bonds have deteriorated, they still appear to be well above March 2020 levels, for both the 5-year and 10-year. As long as liquidity in U.S. bonds does not deteriorate further, the Fed will not intervene as it did in March 2020, especially if one views the recent bond sell-off as a result of investors accepting a reflationary trade.
Bank of America, for its part, believes that the Fed stepping in to some extent and restoring stability to the world’s most liquid bond market is the most pressing matter at hand, even if only with some verbal intervention.
This week, the Fed chairman, as well as other officials, will speak, and it is important to watch how the Fed sees signs of a bond market correction.
Second, as mean reversion signals emerge, CTAs and other momentum traders are hitting oversold levels.
JPMorgan said this will bring at least some temporary relief. But the question is, how far away is the so-called “oversold level”?
According to JPMorgan, the mean reversion signal does play some role, but it is not convincing enough. Last Thursday (Feb. 25), the 10-year U.S. bond yield touched 1.5% while the MoM’s short-term momentum indicator fell to an extreme bearish area of -1.7, although the average of short-term and long-term momentum indicators now sits at -0.8, some distance from -1.2 at the beginning of 2018.
JPMorgan said that for the indicator to reach the lows of early 2018, a further sell-off in U.S. bonds would be required. The investment bank expects a stronger oversold signal when the 10-year U.S. bond yield hits 1.6% and the 5-year U.S. bond yield hits 1%.
Third, investors in Japan and the eurozone stepped in to buy U.S. bonds to benefit from the sharp rise in U.S. bond yields at the level of currency hedging.
The recent sell-off in U.S. debt shows the rising attractiveness of U.S. bond yields based on currency hedging, especially for Japanese investors, but at the current level of U.S. bond volatility, the likelihood of Japanese and eurozone investors entering to buy U.S. bonds is low. Because these investors do not like high volatility, especially the banks.
Not only that, Japanese investors are also selling bonds. The latest weekly data shows that in the week ending February 19, Japanese residents have recorded a net sale of foreign bonds of about $18 billion.
JPMorgan believes that it must rely on other capital flows or Fed intervention to stabilize U.S. bond volatility before it can attract more foreign capital to the U.S. bond market.
Fourth, the rebalancing of capital flows by balanced mutual funds or pension funds will help stabilize the bond market and bring bond yields back down.
JP Morgan notes that unlike foreign flows, the likelihood of such flows occurring in the quarter is high, although the exact timing is more difficult to predict and could occur in late March.
However, there is a potential risk that once these funds rebalance their funds, they may not play a supportive role for U.S. stocks, as they tend to sell off stocks while buying bonds.
After considering the above four scenarios, Xiaomao believes that conditions are not fully ripe for a weakening of the selling pressure in the bond market, the second scenario has seen some signs, and the fourth scenario has some possibility of emergence.
The greatest uncertainty is the Fed, if the U.S. bond yields stop soaring, the Fed is likely to take no action, only when the market continues to turmoil, the Fed may be forced to take action.
The Federal Reserve has fallen into a “trap”, this week’s statement is crucial
This week, a number of Fed officials, including Fed Chairman Jerome Powell, will appear one after another, and their views on the spike in U.S. bond yields will naturally become the focus of attention.
TD Securities U.S. interest rate strategist Gennadiy Goldberg expects two possible scenarios for the bond market this week.
One is that Fed officials could insist that there is good reason for rising market rates, which could accelerate a sell-off in the U.S. bond market, favoring those investors who are short.
The other scenario would be for the Fed to state that it is concerned about expectations of rising market rates and reiterate that they will remain patient, which would benefit investors who are betting that rates will not continue to rise.
Continued high volatility in the bond market would create more risk, and any Fed comments about supporting U.S. bonds would lead to a short squeeze. But if Fed officials say nothing about the topic, it could spur further selling of U.S. bonds.
The Fed is entering a trap, at some point they will be forced to choose between saving the bond market or the stock market.
There is not much Time left for the Fed, and if the bond market sell-off continues, there will be an impact on the U.S. economy as well. As bond yields rise, interest rates on credit card payments, auto loans, business loans, capital expenditures, leases, etc. will also rise, while corporate profitability will decline.
Currently, the economy needs nearly $4.50 of debt to generate $1 of economic growth. Given that the U.S. economy is highly dependent on debt financing for growth, rising interest rates are inherently destructive to the U.S. economy.
More importantly, consumers are also trapped deeper in debt. Currently, the gap between wages and the cost of maintaining a required “standard of living” is at record levels. In order to maintain a standard of living, the American public would need to go into debt in excess of $16,000, and they would have little ability to absorb higher interest rates until spending is significantly curbed.
To close the gap between the cost of living and current income, a deficit of more than $4,000 per year increases the debt burden on consumers, and higher interest rates will further absorb disposable income for debt service.
Thus, when interest rates reach a point where consumers and businesses cannot afford to take on more debt, the credit-driven economy slows.
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