The most difficult trade right now
There's an old saying: the most difficult trade is often the right one. Unfortunately, it does not make for a sound investment thesis, so it's better to be honest and upfront about it.
Given that most fund managers were bullish on long-dated US Treasuries 1% lower in yields on the false pretenses of falling inflation and a US recession, it sets a low bar. Of course, for those who have been on the right side of the recent move are more likely to feel embolden to take an out of consensus bet.
As 30-year USD interest rates rise, automatic stabilizers kick in:
1) New mortgage originations fall—reducing hedging pressure.
2) Fed policy specifically targets housing affordability—the segment of the yield curve which benefits the most.
3) It becomes less attractive for the US Treasury Department and corporates to lock in high borrowing rates, thus reducing net issuance.
In normal times, there is a general scarcity of long-dated high-quality (non-mortgage) bonds and ample demand from institutional investors, such as pension funds and insurers. If mortgage spreads stay constant while interest rates increase, bullet bonds (non-amortizing) become more attractive on relative value.
Based on current front-end USD rates, it is difficult to make a strong case that the 30-year is trading particularly cheap. However, as Craig previously stated, the long-end of the curve is driven entirely by market flows, not policy rates.
We also believe that the Fed has sufficient wiggle room to slow down the pace of rising mortgage rates. Recent hedges and negative gamma from interest rate swaptions mean the risks are more balanced and symmetric. At this juncture, a WSJ headline by “Nick the Greek” alluding to concerns among some Fed officials over rising mortgage rates may be sufficient to trigger a sharp reversal in rates.
Our investment thesis on 30-year US Treasuries may sound plausible, but it's time to ask the real expert on US mortgages, Alan Brazil, what he thinks.
Julia Coronado on the US economy
Here's Julia Coronado of Macro Policy Perspectives talking to Bloomberg Odd Lots. We're not contracted with Julia and her firm, their product is better suited to institutional investors. Having tracked her work for a long time, she comes across as a very smart, sensible, factual and truly independent-thinking economist. Julia first came to my attention in 2013 when she was the only analyst on Wall Street calling for the Fed not to taper asset purchases during the summer of that year. She was right.
We appreciate the way Julia distinguishes between monetary transmission via the credit and policy (rates) channels and her firm's bottom-up, as well as top-down, macro approach.
Up next, the key finding from our investigation in the US Treasury cash-futures basis trade.
The price action in 30-year US rates feels quite challenging at the moment, especially for those who have been long and ridden it more than a 100 basis point move in the wrong direction. Long-dated bonds behave like the San Andreas fault: stable most of the time, but when they move, it's far and fast, causing havoc and mass disruption. If we consider US equities as a proxy for 30-year rates (as the market is currently), they appear to remain resilient. Selling the safest government-backed securities into a potential recession is a bold move. It's more likely a continuation of the unraveling of a flawed investment thesis, consistent with the precursors to a slow-burn crisis, as described by Sir David Omand in recent our interview.
To provide a couple of reference points: since we suggested scaling back on short US rates positions, the current 10-year and 30-year yields have increased by +20 basis points and +10 basis points, respectively. The S&P 500 is marginally higher than when we turned positive on risky assets. Back in June/July 2023, our colleague Craig had a 4.5-4.75% target range on the 10-year (currently @4.75%, then 3.8-3.9%) based on front-end rates at the time (now also slightly higher). The current move is consistent with the repricing he expected.
We also emphasized that trapped bond bulls ought not interpret our reversal as a bullish signal but seize the opportunity to reset and regroup while market liquidity permitted. Time market moves perfectly is more often due to luck than skill.
It might feel very bad right now, but the recent moves are largely consistent and orderly.
Since the dot plots were raised post-FOMC, the only significant economic data release was a PCE inflation report slightly softer than expected. This underscores the flawed nature of the commonly touted yield-inflation thesis. It's a reminder that price action shapes most market participants' perceptions of reality. When this recession finally arrives, neither the bond bulls nor the equity bears will likely be positioned appropriately. Perhaps they'll be vindicated, but with little to show for it, having failed in their primary objective.
Some individuals are very lost and confused. Even the gold bugs are spreading misinformation about US Treasuries exhibiting higher volatility than gold. Absolute nonsense! Let’s not turn this into a Finance and Statistics 101 class amid the market turmoil, we’re professionals.
Your opportunity to shine
Remain calm, sharp, and calculated. Most of all, keep the trust and belief in yourselves. The window for doubt and second guessing has passed. This is where the A, B, and C squads get decided. And we like to see our members do well.
Fortunately, the grown ups have been preparing for significant turmoil in US Treasury markets for over three years.
We're always here to help if we can. Good luck!