Weekly Update

Bonds Are Struggling

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Published April 15, 2022


This week, with all the talk about inverted yield curves and interest rates, we shift our attention from stocks to the newfound misery experienced in the bond market. Money is leaving bonds and rolling into any stock with a tasty yield – e.g. dividend and utility stocks, real estate.

Michael Batnick’s article below talks bonds.

“Only one economic indicator has a perfect track record of predicting a recession. It’s when the yield curve inverts. That might sound jargony, but it’s pretty simple; It’s when shorter-term rates are above longer-term ones, and every time that’s happened since 1955, the economy went into recession between six and twenty-four months later. The recent inversion of the yield curve is shown in this chart of the spread between 2- and 10-year U.S. Treasury yields. They went negative (aka inverted) recently as displayed here by the line dropping below the axis, on the far right. This move brought out buyers, however, as the sharp rebound demonstrates.

Inversion of the yield curve

Typically, you would expect a positively sloping yield curve, where the rates are higher the longer you go out in time. That makes intuitive sense. If you’re going to lend money for ten years, you’d want a higher rate of return than if you were making a two-year loan to the same borrower. A steepening yield curve, generally speaking, means that investors have solid expectations for economic activity. A flattening yield means the opposite, which is where we find ourselves today. Shorter-term rates are rocketing higher as traders prepare for a number of interest rate hikes this year. Longer-term rates aren’t rising as fast, possibly signaling that investors expect that higher rates will slow down the economy.

Aside from just signaling, the shape of the yield curve does have real-world implications. Rising short-term rates make it more expensive for people to borrow money, whether for a mortgage or a small business loan or whatever. Compounding problems, at least theoretically, is that when the curve flattens, banks, who borrow short and lend long, see their margins crimped and might be less willing to extend credit.

It’s always hard to pin down exactly what’s motivating buyers and sellers, especially in the bond market that’s so impacted by the federal reserve. I won’t pretend to be an expert here, so I’ll lean on BMO, who recently said “We’ll be the first to concede the shape of the curve (particularly 2s/10s) doesn’t retain the recessionary signaling power it was once thought to; although this won’t prevent it from weighing further on sentiment in financial markets.”

I guess I’ll take some comfort in the first part of that statement, considering how rapidly the yield curve has flattened recently. Some parts of the curve are already inverted; 10s are below 7s and 30s are below 20. Again, I won’t pretend to know all the dynamics driving price action here, but the usually boring bond market has taken center stage.

Yield curve has flattened

This chart from Eric Balchunas shows a sharp reversal of bond mutual fund flows, which have been a constant vacuum for most of the last decade. It’s still early, but the $65 billion in outflows would be the worst year for flows since they started tracking this data in 2007.

Sharp reversal of bond mutual fund flows

Rates go up, prices goes down, and people sell their bonds. Or is it, people sell, rates go up, and prices go down? Either way, returns are falling at a rate not seen in decades. Bonds are down 2% this month, so assuming that holds, we’ll have the first 5% decline over a three-month period since 1980. And that’s before inflation 😬

Assuming 1% inflation this month with a 2% decline in bonds, investors will be looking at a 7.5% negative real total return for the last three months, also the worst return since 1980.

U.S. Bonds real rolling 3-month return

To make matters worse, bonds have declined alongside stocks for an extended period of time. The S&P 500 and the Bloomberg US Aggregate bond index have both declined for consecutive months ten times since 1976. They’ve never both had negative returns for three straight months. That almost happened for the just completed first quarter of the year. The S&P 500 managed to find a gain in March to avoid setting that losing record.”

Market Update

Stocks gapped down at the open this week as Chinese Covid lockdowns exacerbated supply chain concerns while interest rates continued climbing. The Nasdaq slumped -2.2% in Monday’s trade. A Tuesday morning rebound fizzled leaving stocks off -0.3%. Another high inflation report was met on Wall Street by comment that it was the peak inflation report with future reports showing moderating inflation. Wednesday brought the beginning of the quarterly earnings season with major banks reporting earnings that failed to excite the market. But surprisingly strong earnings from Delta Airlines (DAL) enthused investors sending stocks higher by +1.1% despite a producer price index report that came in higher than expected. That gain was returned Thursday as yields popped higher again to pressure growth stocks once more. Oil prices surged +9% this week though remain well off the $130 level reached a month ago. Markets closed Friday for Good Friday observation.

Stocks slumped again this week with the S&P 500 (SPY) sliding -2.19%. The Nasdaq 100 (QQQ) fell -3.07%. Smallcaps (IWM) closed higher by +0.55%.

Warm wishes and until next week.