Société Générale highlights the risks of a bond crash in 3 charts
10-year note yields, used to set mortgage rates and more, are at their highest in about a year.
As investors stepped on the bond-rout gas on Monday, pushing Treasury yields to their highest levels in months, concerns among strategists ramped up.
Goldman Sachs, for one, warned clients that the speed of the move has them worried about a deeper fallout in interest-rate markets, including vulnerable economies around the globe.
Bond markets, which were closed Friday for the Veterans Day holiday, resumed a vicious selloff on Monday, marking a fifth-straight session of climbing yields beginning last week after Republican Donald Trump beat Democrat Hillary Clinton in the U.S. presidential election. The latest action pushed yields on the benchmark 10-year TMUBMUSD10Y, +2.62% 30-year TMUBMUSD30Y, +0.18% and two-year TMUBMUSD02Y, +6.63% notes to levels not seen in around a year. Bond prices and yields move in the opposite direction.
“The speed of the move is, however, concerning, as the direct and indirect exposure to the ‘lower for longer yields’ theme across asset markets is pervasive.”
Goldman Sachs analyst Francesco Garzarelli
Even before the renewed leg to the selloff began, Goldman Sachs analyst Francesco Garzarelli was warning clients about the possibility of things getting much worse. He said in a note out Friday higher yields aren’t a huge surprise as markets need to replace U.S. inflation expectations from “very depressed levels.”
“The speed of the move is, however, concerning, as the direct and indirect exposure to the ‘lower for longer yields’ theme across asset markets is pervasive,” said Garzarelli, who added that the bank’s analysis suggests in principle there is “more headroom for nominal yields and break-even inflation to rise.”
As might be expected, the bond selloff contradicts a jump in the dollarDXY, +0.75% and gains to record highs for most U.S. stock averagesDJIA, +0.00% which have rallied on the prospect of growth-stimulating, but deficit-widening, economic policies from President-elect Donald Trump. The S&P 500 index SPX, -0.11% has seen more comparatively muted, but still strong, gains.
With growth expectations come higher inflation expectations. And that leads to a repricing in the long end of the Treasury yield curve as investors demand to pay less and capture a higher premium for assuming increased risk of inflation, which erodes real returns. A flurry of bond issuance to fund federal spending could also aggravate a rise in bond yields as more bond supply crowds the market.
Garzarelli expects Trump’s triumph at the polls to drive the yield on the 10-year Treasury to 2.5% in 2017, which could be faster than the investment bank previously forecast.
Europe, too
Also worrying Goldman Sachs and other investment banks is spillover from the U.S.-bond selloff to the euro area. The U.S. move has pushed real rates higher across the region, notably in past trouble spots of peripheral markets that are still struggling with high debt.
Garzarelli said the European Central Bank needs to get out in front of damaging, rising credit-risk premiums on countries such as Portugal, Italy and Spain. “But before the ECB shows its hand, the market could be in a worse position,” he warned.
“This is why we think that the ongoing exuberance around even faster U.S. reflation post the U.S. election may prove ultimately self-defeating without much more convincing signs of a growth upswing,” said Garzarelli.
The latest leg of the bond-market selloff persisted on Monday despite weak retail and output figures out of China, which suggested a pause in growth momentum in the world’s second-largest economy.
“The fact that this selloff happened despite disappointing data in China also highlights just how U.S. focused this selloff is,” said Aaron Kohli and Ian Lyngen, a team of fixed-income strategists at BMO Capital Markets, in a research note published Monday.
A crash takes shape?
Strategist Daniel Fermon at Société Générale, in a note to clients on Monday, laid out three charts that to him highlight risks of a bond crash. The first shows how inflation expectations are bottoming out as job creation has hit a 10-year high and wage growth has been on the rise.
“Accordingly, in October 2016, core inflation could rise to 2.3%, YOY, higher than the Fed target of 2%. It could even peak at 2.7% in the U.S. in 2017,” said Ferman.
A second chart shows how deflation fears have eased, but bond yields have risen over the past three months in most developed countries:
A third snapshot from Société Générale shows how nominal yields remain low, and probably can’t go much lower:
“As central banks are now less active in the bond market and Trump expects to cut taxes and launch a $1tn infrastructure investment plan, increasing the deficit, we believe rising U.S. long-term rates remain a major risk for financial markets,” said Fermon.
Goldman Sach had this advice for investors who find themselves rattled by the bond trade right now.
They suggested remaining long on 10-year TIPS, or Treasury inflation-protected securities, for at least another 25 basis points of yield change. TIPS are indexed to the Consumer Price Index to give investors some protection from a rise in inflation.
They also suggested investors remain wary of peripheral-economy bonds until the market knows the European Central Bank’s intentions in December. Finally, they advised looking at diversifying into Japanese bonds, especially after the introduction of the zero-yield target in 10-year bonds by the Bank of Japan in September.
— Rachel Koning Beals and Joseph Adinolfi contributed to this article
Read this article in its original format at MarketWatch.com
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