Bond Market Sell-Off Is Part Of Larger Ten Year Trend
By Mark Melin
The pace of the bond market selloff has been strong enough to give yield curve traders whiplash. Coming into July government bonds were on track for their largest gains since 1986, Bank of America Merrill Lynch’s Chief Investment Strategist Tom Hartnett noted in a December 1 report. The move in interest rates is skewing his investment recommendations, but investors should also consider risk triggers that might emerge.
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Bond market selloff – 2016 has been the year of trend reversals, particularly in bonds
The market environment this year is worth considering in light of a new direction.
In the wake of the January / February “V bounce low,” commodities, global stocks & US High Yield are all up over 20%, Hartnett notes, pointing to the end of the OPEC price war & Yellen’s Humphrey-Hawkins testimony as causation.
Then July and the Brexit materialized along with clarity on the US Presidential party nominations.
Yields on the US 10-year Treasury note bottomed on July 8, 2016 at 1.366%, just as the nominations for US President were being established and a historic presidential election was about to take place. They steadily rose higher to 1.862% four months later and then significantly spiked after the US Presidential election result was official, currently trading at 2.39%.
Big action has occured in the bond market. Since Brexit, the 30-year Treasury has lost 13% in value, the gold price is down 10%, while global bank stocks are up 25%. After Trump’s victory, the 3-month T-bills are the only fixed income class not in the negative column, and the British pound is the only major currency to have appreciated versus the US dollar.
Odd trend reversals that point to a market environment going forward.
Bond market selloff
Short term watch for trend reversal, longer term trend continuation is likely to occur
With the US Federal Reserve set to hike the Fed funds rate 25 basis points on Dec 14th, the longer term trend has further to run even if inflation winners such as industrial metals & banks tactically overbought. Hartnett defines this on technical terms, as they have traded two standard deviations above their average price. Likewise, deflation winners such as telecoms, staples and utilities are now oversold near-term.
While some consolidation of what Hartnett calls the “GR8 Rotation” is likely, “the broader trend has significantly further to go.” In some asset classes, such as investment grade and high yield credit opportunities and tech stocks, the trend “is only just starting.”
Hartnett points to equity flows to bond funds reversing. In the past 10 years, global bond funds have attracted $1.5 trillion more assets than global equity funds — which have attracted net zero. This flow has “only started reversing” since the Trump election.
Just as stocks have seen inflows, there is a similar pattern in inflation vs yield assets. Investment grade, high yield and emerging market debt, as well as REITS and dividend funds have seen $1.1 trillion inflows since 2009. Compare this to a mere $330 billion inflow to “inflation” plays such as European, Japanese and emerging market stocks markets. These trends are now reversing. Also watch for value stocks to outperform growth stocks, another trend unwind.
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Bond market selloff
Bond market selloff aside – Watch the trends with the risk triggers as well
To Hartnett, this plays into a higher growth, higher inflation, higher rates outlook where long stocks, real estate, commodities & US dollar and short bonds benefits.
Looking at 2017, he expects double digits for stocks in Japan, Europe, and the UK, as well as oil. Single-digit returns are expected for US stocks, commodities, US dollar and emerging markets. Hartnett is looking for low to negative returns on bond investments.
While he notes that interest rates are typically not a concern until they reach 5%, that doesn’t mean volatility won’t come into play:
Bond volatility and credit spreads for signs that a credit event is coming: the worry is that the sharp rise in yields causes an “event” at a financial institution excessively levered in the “zero rates forever” trade. As of yet, most risk barometers are quiet and credit spreads are well behaved. Italy’s referendum will be another test: watch peripheral bond spreads. The immediate lack of widening post the BREXIT & the US election votes inspired the rally.
In the end, the “Trump rally” will only continue as long as macro-economic data continues to come in. In this environment investors need to watch for the risk triggers.
“The risk is that investor euphoria coupled with higher inflation will force the Fed to signal a more aggressive tightening cycle, resulting in a classic boom-bust market sell-off,” he wrote. “On the other hand, if it becomes clear that the rise in interest rates is stagflationary, then expect a reversal of the deflation to inflation rotation and a more severe market sell-off.”
Disclosure: Author has no position in MRK.
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