Bond market: Bondholders look to recession for salvation after vicious first half

Treasury holders, reeling from the harshest first half on record, are beginning to bet that a deterioration in the economy will bring some relief from the relentless sell-off, even as they brace for the risk of greater weakness.

As the specter of recession looms daily, expectations about where U.S. policy rates might go are being reduced and some bond buyers are getting their toes back into investments at these new higher yields. But inflation is far from over and there are fears that the rout of the first half – which saw nearly 14% wipe out global bond portfolios despite falling stocks – could continue even if growth stagnates.

The last six months of 2022 “shouldn’t be as ugly as the first half of the year, but it won’t be pretty,” JPMorgan Chase & Co. rate strategists led by Alex Roever said in a note. In their view, the ongoing battle between inflation and recession risks will drive yields higher from their current levels as the Treasury curve flattens.

Of course, a situation worse than the last six months for bonds is difficult for many to envisage simply because it has already been so bad. By one calculation, US debt performance has been worse than at any time since even before the US Treasury Department was established in the late 1700s. Based on widely followed Treasury indexes, investors endured a more painful first half than any going back to at least the early 1970s.


Holders of US debt are not the only ones taking the hits. The inflationary spiral, caused by the Covid pandemic and exacerbated by the war in Ukraine, has spread globally. With the Treasury bill index posting a nearly 10% loss from January to June, upward pressure on rates spread everywhere from Germany and Italy to Brazil and New Zealand. Even Japan – long the stronghold of ultra-loose monetary policy – ​​faces pressure to give way to higher yields.

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The recession versus inflation dilemma is potentially crippling for Treasury market investors struggling to know which strategies to adopt, especially at a time when low market liquidity is helping to drive outsized moves and increased volatility.

The earlier

into short positions in the bond market – those that benefit from higher yields – was halted and reversed. However, few are betting on significantly lower returns either and the positioning seems fairly balanced. And while derivatives trading that protects against the tail risk of dramatically higher or lower rates is attractive to some market participants, general conviction is low.

“Have we experienced a spike in inflation? I think we have a very good probability, but it’s hard to predict,” said Janet Rilling, senior portfolio manager at Allspring Global Investments, which manages $541 billion in assets. “What is simpler is to say that inflation will remain quite high. But even if we stay elevated, the Fed has work to do. In our view, the Fed will continue to be aggressive.

This expectation of hard-hitting rate hikes from the central bank – and concern about how this might affect growth – is evident in the pricing of front-end derivative contracts. Traders still believe a 75 basis point rally is slightly more likely than a 50 bps move in July, and they see the benchmark – currently in a 1.25% to 1.5% range – increase to around 3.3% per year. end.


But prices beyond that suggest they won’t rise too much, peaking at less than 3.4% in the first quarter, with the Fed then forced to cut more than half a percentage point before the end of 2023. This is quite a marked change from just a few weeks ago when the terminal rate was above 4% and likely to occur around the middle of 2023.

Meanwhile, market expectations for the pace of consumer price gains have also come to light, with so-called breakeven rates on inflation-protected Treasuries at an average annual rate of around 2. 36% for the next decade.

Erin Browne, fund manager at Pacific Investment Management Co., is among those who believe the economy is “near a tipping point where inflation will smash growth.” She says that once inflation “starts to peak” she will look to buy Treasuries in the 2-5 year sector as they will benefit when traders start to price in the type of dips more aggressively. rate that the Fed may eventually have to implement. .

Saira Malik, chief investment officer at Nuveen, said her firm was taking “small steps” to increase exposure to the bond market again. “The Fed needs to see a steady moderation in inflation data points before they can ease off with rate hikes. And it will be hard for them to avoid a recession,” she said.

This backdrop leaves the upcoming holiday shortened week ripe for more volatility – with some metrics near their highest levels since March 2020 – and further random surges in liquidity. The June jobs report and key job vacancies data will be the focus of the coming week, as Powell pointed out, in order to reduce inflation, the central bank must calm the labor market American “unsustainably hot”.

On top of that, there’s the potential impact recession fears will have on riskier assets like equities, and the flow effects on Treasuries. Big moves in the S&P 500, which just posted its worst first half since 1970, could be a catalyst for new inflows and outflows of bonds, especially now that market participants have cleared the hurdle quarter-end rebalancing. And just as importantly, market moves could ripple through the real economy as consumers begin to factor in the significant shifts in wealth that occurred when stocks and bonds were hammered.

“The wealth effect of stocks and bonds is huge,” said Gene Tannuzzo, global head of fixed income at Columbia Threadneedle. He believes that the data will start to show both a slowdown in growth and inflation in the third quarter and that while the Fed has yet to follow through with the actual implementation of its hikes, the “peak in yields of the Treasure is getting closer.”


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