Bond investors at sixes and sevens on inflation
We learnt last week that US inflation hit 6.2% in October. That’s the highest rate since November 1990, the month in which “Home Alone” was released in cinemas and Margaret Thatcher resigned as the British Prime Minister.
Whichever way you choose to slice and dice the data, inflation pressures look to be broadening. On the Atlanta Fed’s underlying inflation dashboard, there are now a lot of red lights flashing and there are growing warnings of a peak at or above 7% in the months ahead.
But the bond market has been a fickle friend to the vigilantes this year. Anyone who had sold out of the longest-maturity bonds in the spring, in anticipation of the string of upside surprises on inflation, has been disappointed – with 30-year futures rallying by over 10% since March. The financial media have been full of anecdotes in recent weeks of storied macro hedge funds suffering gut-wrenching losses on bond trades gone awry. The most popular ill-judged position has been the so-called “steepener” trade: betting on long-maturity yields rising faster than short-dated maturity.
In fact, the opposite has been happening consistently since May. As central banks have pivoted to focusing on inflation concerns, they have rewritten “forward guidance” that had previously been regarded as sacrosanct. Short-term yields have risen sharply in certain markets as a result, with Eastern Europe, Australia and the UK in the vanguard of the repricing. Longer-dated yields have barely moved, or even fallen.
Sooner or later?
Why has that happened? One simple logical conclusion is that if the central bank concerns about inflation are growing, then investors need to worry less about the prospects of it getting out of control in the medium term. Put another way, the sooner that the hiking cycle starts, the less aggressive it needs to be to bring aggregate demand and inflation back down to earth.
As positions have soured, there has been more self-serving commentary about an unfolding central bank “policy mistake”. Flattening yield curves have, historically, been a leading indicator of economic downturns, so the charge is not entirely without merit.
But it strikes me as a good example of “attribution bias”: the tendency to attribute success to your own actions and blame failure on the actions of others. It’s much easier to argue that someone else is making a policy mistake than to admit that you’ve made an investment mistake.
Recent price action suggests that, in the wake of those losses, there has been considerable forced liquidation of positions. For us, that “cleaning up” of the market makes it interesting to sell government bonds again. It’s an investment strategy we’ve been using repeatedly this year: reducing duration (i.e. interest-rate sensitivity) whenever consensus positions have been trading under stress, and increasing again when the market commentary gets too obviously one-sided and confident in its outlook.
In 1990, Kevin McCallister was busy defending his home against the Wet Bandits and Margaret Thatcher was unsuccessfully fighting off the Tory “wets”. At the time, 10-year US Treasury yields were above 8.5%. The contrast with today could barely be more different, with yields now at the dizzy heights of 1.6%.
To be clear, we’re not expecting a return to anything even remotely close to the levels we saw 30 years ago. However, we think that some sterner words from the Federal Reserve await in the weeks ahead that could push yields back up again. With bond investors at sixes and sevens over inflation this year, we think it’s time to take pre-emptive action to reduce our overall interest-rate sensitivity. Hopefully, a stitch in time can save nine.