Bond market meltdown

My bullish equity thesis from last week was based on my view that the gilt bond market meltdown would resolve itself - that there would be a policy U-turn that would bring stability back to the market and alleviate the forced selling of risk assets and gilts by UK pension funds. That has come to pass - Truss and Kwarteng have left office, and we will soon be getting a new PM who will (hopefully) deliver a more fiscally sustainable budget. The gilt market has stabilized, although it hasn’t reversed the downtrend.

Unfortunately another elephant in the room is rearing its ugly head, preventing the equity market from staging a meaningful recovery. That elephant is the long dated Treasury market, which makes the smaller gilt market look like a shrew in size and significance. It’s clear that turbulence in the bond market has not resolved itself and is in fact accelerating, and for that reason I have closed out all leveraged risk on trades and just keeping my long equity exposure in unlevered cash equities, a large portion of which are energy ETFs. The positioning dynamics are still supportive for the S&P 500, but I don’t think it’s wise to be a hero and be leveraged long in this kind of environment.

Let’s start from the beginning. A long time ago, in a macro regime far far away, there was this concept in the Treasury market called the Treasury term premium. The term premium is the additional yield bond investors get as compensation for locking up their capital in a bond that wouldn’t pay your principal back until 10 to 30 years later. During the time your capital is waiting to get returned, anything could happen - the government could default, inflation could skyrocket, interest rates could go up, you might need to sell at a loss because you needed that money back sooner than expected, so naturally one should get some extra yield in return for not having your principal guaranteed to be returned for such a long time. And indeed, investors did receive a term premium of anywhere between 1-5% in the pre-Greenspan era.

Then came the era of zero interest rate policy and QE. The term premium compressed to 0%, and then went negative post GFC. This happened for several reasons:

1. The 60/40 equity/bond portfolio came in vogue as equity/bond correlations were negative for most of this period, and allowed investors to use bonds as an effective diversification tool. The secular downtrend in interest rates rewarded institutions for investing in bonds alongside their equity portfolios, reinforcing this behavior even as bond yields became razor thin or negative. Pension funds continued to allocate to bonds in a systematic and price insensitive fashion even as the mountain of negative yielding debt reached $15T in 2020-2021.

   

   Negative yielding debt, in millions of USD

2. Asian and Middle Eastern countries amassed huge reserves of US dollars (for reasons I won’t get into), and needed a place to park them (the Treasury market).

3. Zero interest rate policy in Japan and Europe made it profitable for Japanese and European pension funds and institutions to buy US Treasuries and hedge the FX risk to get a “risk free” yield pick up on top of their local government bond markets, so they did this in huge size.

4. Quantitative easing by the Fed introduced a new and large buyer to the Treasury market that all the market players above had to compete with.

Today we are seeing this process work in reverse, and therefore I expect term premium to go positive again from its negative levels today (unless the Fed gets in the way). Let’s take #1-4 from above and observe how each are now working in reverse.

1. All the pension funds that bought low to negative yielding bonds are now suffering 30-50% marked-to-market losses on those bonds. In theory, they could refuse to crystalize these losses by holding the bonds to maturity, but the reality is that some of them bought using leverage and are now forced sellers in order to meet margin calls.

2. Asian central banks are drawing down their reserves to intervene in the FX market and support their weakening currencies. China’s central bank has been selling USD almost every day to support CNY, but in order to sell USD they need to sell Treasuries first. The Bank of Japan spent $21B to intervene in the yen currency market last month, much of which was funded by selling Treasuries (I wouldn’t be surprised if they intervene again, with usd/jpy now trading above 150).

3. The Japanese pension funds and banks that bought Treasuries and hedged them to pick up extra yield are now choking on huge marked-to-market losses that are hurting their capital position. It’s unlikely they will be meaningful buyers anymore in this market environment. In fact, Japanese institutions have been net sellers of Treasuries this year.

   

   Net purchases by Japan of US Treasury bonds

4. Quantitative easing has turned to quantitative tightening by the Fed. Everyone, including the Fed, has turned from a buyer to a seller of government debt at the worst possible time - when inflation is soaring and the Fed is aggressively hiking rates.

We have entered a supply-demand deficit in the long dated government bond market, as everyone who was previously a buyer is now sitting on their hands or has turned into a seller. The only thing that will attract demand will be one of two things - term premium goes positive enough to reward institutions for purchasing long dated Treasuries, or we have some catastrophic breakage in the Treasury market (similar to March 2020) that forces the Fed to step in and start buying Treasuries again.

I’ve been short Treasuries in fits and starts this year, and I’m going short 30 yr Treasuries again:

Fidenza Macro @fidenzamacro

Gone short 30y Treasuries. It’s clear they are heading in only one direction, and that is down, regardless of what happens in UK economy/politics, regardless of US data. If there is anything that craters equities, it will be the Treasury market. It’s a hedge for long equities.

At the moment the market is deeply oversold, so I would wait for a rally or go short via puts. The 30 yr yield today is 4.28%, and if any semblance of term premium returns, it should be at 5.25% or higher within a 3-6 month time horizon. The risks to this trade are weak employment and inflation data, a dovish turn by the Fed, or new Fed policy that frees up capital for banks and other market players to buy long-dated Treasuries.

Most of you probably don’t trade 30 yr Treasury futures, so the takeaway should be:

1. Don’t be long TLT or other long bond ETFs

2. 10-30 yr yields have a lot more upside in the long run as term premium returns, so prepare for that in your finances and portfolios.

3. If the Fed intervenes to support the bond market, all bets are off and we will enter a risk on, weak USD environment again. Buy commodities, equities, and crypto.

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