The $24 Trillion Treasury World Suddenly Looks Less Dangerous


(Bloomberg) — The historic bond sell-off has wreaked havoc on global markets all year, while fueling a crisis of confidence in everything from the 60-40 portfolio complex to the world of Big Tech investment.

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Now, headed for a potential economic downturn, the nearly $24 trillion Treasury market is suddenly looking less dangerous.

The latest consumer price data in the US suggests that inflation may finally cool off, causing investors to flock back to the asset class on Thursday, as traders downplayed their bets on the Federal Reserve’s hawkishness. Another reason this once-trustworthy safe haven seems safer than it has been in a while: Even rising interest rates have less power to destroy bond portfolios as they have for the past two years.

Just look at duration, which measures the sensitivity of bond prices to changes in yields. It’s a time-tested measure of risk and reward that guides all flavors of fixed income investing – and it’s fallen sharply this year.

With the Fed’s aggressive policy-tightening campaign this year, which has pushed Treasury yields to about a decade high, the margin of safety for anyone buying U.S. debt right now has improved significantly compared to the low-yield era before the bull market collapsed. in the wake of inflation. of the pandemic.

Thanks to higher yields and coupon payments, simple bond calculations show that duration risk is lower, meaning another sell-off from here on would cause less pain for money managers. That’s a merciful prospect after two years of heartbreaking losses on a scale largely unseen in the modern Wall Street era.

“Bonds are getting a little less risky,” said Christian Mueller-Glissmann, head of asset allocation strategy at Goldman Sachs Group Inc., which moved from underweight bonds to neutral in late September. “The overall volatility of bonds is likely to fall because you don’t have the same maturity, and that’s healthy. On a net basis, bonds are becoming more and more investable.”

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Think of the two-year Treasury bill. According to analysis conducted by Bloomberg Intelligence strategist Ira Jersey, yields would need to rise as much as 233 basis points for holders to actually take a total loss over the next year, mainly thanks to the buffer provided by hefty interest payments.

With higher returns, the amount an investor is compensated for each unit of duration risk has increased. And it has raised the bar before a further increase in yields causes a capital loss. Higher coupon payments and shorter maturities can also serve to reduce interest rate risk.

“The simple arithmetic of bonds of rising yields leads to a decline in duration,” said Dave Plecha, Global Head of Fixed Income at Dimensional Fund Advisors.

And take the Sherman ratio, an alternative measure of interest rate risk, named after DoubleLine Capital’s deputy chief investment officer, Jeffrey Sherman. On the Bloomberg USAgg Index, it rose from 0.25 a year ago to 0.76 today. That means it would take a rate hike of 76 basis points in one year to offset a bond’s yield. A year ago, it would have cost just 25 basis points, equivalent to a single regular Fed hike.

All things considered, a key measure of duration on the Bloomberg US Treasury index, which tracks around $10 trillion, has fallen from a record 7.4 to 6.1. That’s the least since around 2019. While a 50 basis point rise in interest rates late last year caused a loss of more than $350 billion, that same blow is now a more modest $300 billion.

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That’s far from clear, but it does reduce downside risk for those wading back to Treasuries attracted by earnings — and the prospect that lower inflation or slowing growth will push bond prices higher in the future.

Read more: High-end duration is the sharpest drop since Volcker Hikes

After all, cooling US consumer prices for October offers hope that the biggest inflation shock in decades is easing, in what would be a welcome prospect for the US central bank when it meets next month to predict a likely 50 basis point hike in benchmark rates. realize .

Two-year government bond yields rose to 4.8% this month — the highest since 2007 — but fell 25 basis points on Thursday, according to the CPI report. The 10-year yield, now hovering around 3.81% from 1.51% at the end of 2021, also fell 35 basis points over the past week, which was shortened due to Friday’s Veterans Day.

The counterpoint is that bond buying is far from a slam-dunk trade given the lingering uncertainty over the inflation path as the Fed threatens further aggressive rate hikes. But the math suggests that investors are now slightly better compensated for the risks across the curve. That, along with the obscuring economic backdrop, has convinced some managers to slowly rebuild their exposures from multi-year lows.

“We have hedged underweight durations,” said Iain Stealey, CIO for fixed income at JPMorgan Asset Management. “I don’t think we’re completely out of the woods yet, but we’re definitely closer to peak yields. We’re significantly less underweight than we were.”

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And of course, the recent rally suggests that an asset class that has fallen sharply out of favor over the past two years is finally turning the corner.

The defining story of 2023 will be “a deteriorating labor market, a low-growth environment and moderate wages,” BMO strategist Benjamin Jeffery said on the company’s Macro Horizons podcast. “All of this will amplify these safe-haven dip purchases, which we claim have become a reality in recent weeks.”

what to watch

  • Economic calendar:

    • November 15: Empire production; PPI; Bloomberg November US Economic Research

    • November 16: MBA Mortgage Applications; retail trade; import and export price index; industrial production; business supplies; NAHB Housing Index; TIC flows

    • Nov 17: Start/permits for housing; Business Outlook Philadelphia Fed; weekly unemployment claims; Kansas City Fed Production

    • November 18: Existing home sales; leading index

  • Fed Calendar:

    • Nov 14; Fed Vice Chair Lael Brainard; New York Fed President John Williams

    • November 15: Patrick Harker, president of the Philadelphia Fed; Fed Governor Lisa Cook; Fed Vice Chairman for Oversight Michael Barr

    • Nov 16; Williams delivers keynote address at the 2022 US Treasury Market Conference; barr; Fed Governor Christopher Waller;

    • November 17: St. Louis Fed President James Bullard; Fed Governor Michelle Bowman; Cleveland Fed President Loretta Mester; Fed Governor Philip Jefferson; Minneapolis Fed President Neel Kashkari

  • Auction calendar:

    • November 14: 13 and 26 week bills

    • November 16: 17-week bills; 20-year bonds

    • Nov 17: 4- and 8-week bills; 10 years of TIPS Reopening

–With help from Sebastian Boyd and Brian Chappatta.

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