Surging rate-cut expectations and a desperate lunge for safe assets amid the coronavirus outbreak have earned the bond market a lot of fans in recent weeks. The resulting rally is creating a few detractors, too.
A growing chorus of strategists and money managers is voicing concern as investors charge into government debt at seemingly any price.
The fear is they’re exposing themselves to interest rate risk like never before, risking a precipitous slump on even a modest bump in yields. One breakthrough in the fight against the illness, or a sign the global economy is recovering faster-than-expected, might be all it takes.
The yield on 10-year Treasuries touched an all-time low on Monday but traders didn’t have to look far for clues of just how fast the narrative can change. The S&P 500 Index surged 4.6% on bets central banks would coordinate to limit the economic impact of the virus. The moves highlight belief in some corners that policy action will stoke growth, creating upward pressure for stocks and bond yields.
“If things go a little better -- if there is a cure in the next two, three months or if with warmer weather the virus fades -- then long-end rates will sell off,” said Alberto Gallo at Algebris Investments. “Duration is expensive to protect the portfolio.”
The London-based money manager said he’s using short positions in credit to hedge the risk of a deeper sell-off.
Amid a rally so ferocious that it has stirred speculation some Treasury yields could even be headed below zero, the danger of rising bond yields still seems remote. Even those flagging it as a concern aren’t ready to unwind their bets on longer bonds -- for now.
The Federal Reserve’s announcement Friday that it was ready to act if needed took 10- and 30-year Treasury yields to new lows, with futures markets now pricing in more than 100 basis points of Fed cuts this year. The announcement by the Fed, a rare departure from typical central bank protocol, ushered in similar assurances from the Bank of Japan and the Bank of England.
The yield on the Bloomberg Barclays Global Aggregate Bond Index, which includes developed and emerging-market debt from governments and corporations, tumbled to 1.05% Monday, its lowest ever.
Still, the risks of taking one-way bets on bonds at such elevated valuations loom large. Sensitivity to changes in rates measured by duration is running at a record 8.6 years in the Bloomberg Barclays Global Aggregate Treasuries Index. That means every percentage point increase in average yields would spark a price decline of about 8.6%.
Bond traders throwing their faith behind policy makers should also be thinking about how steps to shore up confidence will affect those bets, according to Jim McCormick, the London-based global head of desk strategy at NatWest Markets. A boost to economic growth would ultimately mean higher long-dated yields.
“Central banks will likely cut and unlikely unwind them when things settle, but a recovery plus more fiscal policy should pressure the back end of the curve,” he said. “The curve steepens if the combination of policy response works.”
A sobering assessment by the OECD Monday did little to assuage market panic. The Paris-based group warned of possible global contraction this quarter and cut its full-year growth to just 2.4% from 2.9%, which would be the weakest since 2009.
As the number of new virus cases in China declines, those elsewhere are climbing, with countries like Brazil and Pakistan reporting instances of the illness for the first time.
But if measures to contain and stamp out the illness take hold, China returns to work and records an upswing in growth in the second quarter, bets on expensive government bonds may start to look dangerous.
Bond momentum signals tracked by a type of systematic investors known as trend followers have turned so extreme their bullish bets are now vulnerable to profit-taking, according to JPMorgan Chase & Co.
Wariness is reflected in passive flows in the world’s most heavily traded government debt product, the iShares 20+ Year Treasury Bond fund, which shows investors’ love affair with duration may be cooling somewhat. The ETF just posted its largest weekly outflow in more than a month.
“Chasing bonds when yields are at an all-time low seems very risky,” said Mark Dowding, a money manager at BlueBay Asset Management, who has a neutral stance on duration. “At the same time it seems that news flow on the virus will get worse before it gets better.”
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