(Bloomberg Opinion) – Bonds, Bears, the Fed and Nancy Pelosi
A bear market in bonds has been a long time coming — it’s about four decades since the last one ended. And after the US saw inflation hit its highest levels in 40 years (since the bond bull market started), fueling bets that the Federal Reserve would embark on the most aggressive tightening campaign in a generation, it seemed that the bear market had finally started.
But cold feet remain. Yields have dropped precipitously in recent weeks, despite the lack of any clarity that inflation is over. And that led to an extraordinary trading session Tuesday as they boomeranged back upward. House Speaker Nancy Pelosi can claim a starring role with her fraught visit to Taiwan. Barring only the two worst days of the first Covid shutdown, and the Monday in June when the Fed leaked its intention to hike by 75 basis points at its next meeting, this was the biggest daily gain for 10-year yields in five years:
How has this happened? Over the last 40 years, whenever the trend appeared to be about to break, the Fed would respond with cheaper money and bring yields back down again. Its emergency response to the pandemic helped rates to drop to record lows in 2020. With the return of inflation, that pattern appeared to have broken, leading to this year’s surge in yields. But since June, it has been as though the market trod on a rake. Ten-year yields dropped by a full percentage point:
At present, the Bloomberg Global Aggregate Index, which tracks total returns from investment-grade government and corporate bonds, has slumped roughly 12% since the beginning of the year — a significant move for an asset that is prized for its stability. The broader ramifications are severe, as bonds have not played their usual diversifying role in contrast to equities, raising doubts on the endurance of the classic “60/40.” According to Bloomberg’s index, a 60/40 portfolio in the US would have lost 19% for the year until bonds’ June turn.
How do we explain that pivot? Evercore ISI’s Ed Hyman, who started the year expecting 10-year yields to reach into a range between 4% and 5%, offers this handy checklist of all the events of the last seven months that have given investors an incentive to buy bonds once more. They are in roughly descending order of importance — profound for the Ukraine invasion, more ambiguous for other developments:
1. Russia’s invasion of Ukraine
2. House Speaker Nancy Pelosi’s trip to Taiwan
3. Likelihood of getting financial shock or crisis
4. Plunge in M2 growth, the broadest measure of money supply
5. Various signs inflation is cooling
6. Weakness in housing market
7. Economy in recession
8. Disaster in Europe
9. Middle East risk
10. Climate change
In a video to clients, Hyman said he didn’t at first believe the “transitory inflation” story, which was why he predicted that bond yields and the fed funds rate could rise as high as 5%.Other analysts also offer reasons for continuing lower yields. Bank of America predicts that 10-year yields could get back down to 2% within the next six to 12 months, amid a more significant economic slowdown. Bank strategist Bruno Braizinha said the 10-year yield at around 2.6% is consistent with the bank’s fair value range of 2.35% to 2.65%. He admitted:
The recent pivot in market focus away from inflation and towards deteriorating growth fundamentals pushed 10yT yields towards its fair value range faster than we had anticipated. To a large extent, the easy part of the rally is over. A further rally from here is possible and even likely, but how much further depends on a series of fundamentals and more technical drivers.
Those drivers include the possibility that investors realize that stocks are too expensive and sell them to buy bonds as a recession takes hold; the risk that the unrolling slowdown isn’t a soft landing (the current implicit forecast), which would again prompt buying bonds; and the scarcity of other haven assets. Sterling and the yen are not seen as the safe redoubts they used to be, for example, and Treasuries increasingly offer a lonely haven.
All of those long-term factors will not go away. In the short term, however, it turns out that the fall in bond yields has been taken too far. Tuesday’s macroeconomic data gave no particular reason to sell bonds; indeed jobs vacancies numbers suggested that the labor market was slowing a bit. Instead, the words and actions of a few women were enough to push yields higher.
First, there was “Fedspeak.” Several Fed governors spoke on the record during the day, and all suggested that the dovish gloss investors put on the last Federal Open Market Committee meeting was over-hopeful. In particular, the San Francisco Fed’s president, Mary Daly, said that the Fed was “nowhere near” done with fighting inflation, while Loretta Mester, who heads the Cleveland Fed, said she would need “compelling evidence” that inflation was coming down before any pivot on monetary policy. With the Fed now eschewing forward guidance and reacting to data as it comes, Fedspeak like this promises to be that much more important, and to provoke that much more volatility. The jawbone is back.
The other woman to move the market was, of course, Nancy Pelosi. News that she was going through with a visit to Taiwan, with all the attendant geopolitical risks, prompted a rush into bonds as a haven. The situation remains tense, but the lack of an immediate Chinese military response calmed everyone down, and allowed bond yields to rise sharply. It’s hard to find much commentary supporting Pelosi; you might read these pieces by Bloomberg Opinion’s own Minxin Pei; Thomas Friedman of the New York Times (whose Bret Stephens was one of the few who welcomed the visit); or my old Financial Times colleague Edward Luce. Pelosi defended herself in the Washington Post.
Did all of this add up to an overwhelming driver for one of the biggest Treasury selloffs ever? No, of course it didn’t. But it’s in the nature of markets to overshoot, and they had taken yields too low too fast before Tuesday’s excitement. Bloomberg’s Ruth Carson and Charlotte Yang write that it may take time for the impact of Pelosi’s visit to ripple through global markets. For the future, the cocktail of geopolitical and economic risks leaves room for any number of scenarios — it’s best to expect more bond market volatility.
—With assistance from Isabelle Lee
The Losers’ Game
How can stock pickers beat the market? Over the last two decades, the arguments for passive management have won year by year. After costs, most actively managed portfolios can be expected to lag an index, which can be tracked ever more cheaply. That math has now come full circle, as the debate has moved on to the concerns over whether a market can function efficiently if most of the money in it is being held passively and won’t respond to changes in price.
However, while the odds in this way will always be stacked against active managers, that doesn’t mean that all times are equally difficult for them. For a simple proxy for the opportunities the market has offered to stock pickers over time, look at the performance Hedge Fund Research of Chicago’s Equity Hedge index, relative to the S&P 500, since the HFR index started in 1998:
Hedge funds were able to use their advantages, such as lockup periods and the ability to sell stocks short, to outperform massively during the bursting of the internet bubble in the early 2000s, and again to a more limited extent during initial salvos of the Global Financial Crisis. Since then, it’s been downhill all the way, with the last few months looking like their best revival in more than a decade.
Some of this is due to the hedge funds themselves. There are more now, their quality has been diluted, and they tend to be more cumbersome and institutionalized. But a lot of this has been driven by the nature of the market. While central banks have been pumping money into the stock market, it’s become much harder for smart hedge fund managers to find opportunities for profit.
Breaking the opportunities for stock pickers down, they center on two concepts — correlation, or the amount that stocks tend to move in the same direction as each other, and dispersion, or the degree to which stocks’ returns differ. As this chart from David Kostin, chief US equity strategist of Goldman Sachs Inc. shows, correlation has risen sharply in the last few months. (In other words, everything has been falling together, with occasional interludes when everything rebounds together):
That’s not great for stock pickers. The news on dispersion is more nuanced. Earlier this year, dispersion spiked well above its norm for the last four decades — a phenomenon that can be attributed variously to the differing impacts of higher oil prices, reopening after the pandemic, and rate hikes. All of this was good for stock pickers, and perhaps helps to explain why equity hedge fund managers have had better luck of late. But now, unfortunately for them, dispersion has dipped right down again:
Beyond the opportunity set for portfolio managers, dispersion and correlation and the way they interact with volatility can tell us a lot about the kind of selloff that a market is experiencing. As these charts from Societe Generale SA demonstrate, there was massive dispersion after the dot.com bubble (when the valuations of some stocks were crazy but the economy was not in great trouble), but much less dispersion during the Lehman crisis (when everyone appeared to be going to hell in a handbasket at once), and even less during the Covid lockdown (when the end of the world, equally bad for everyone, appeared to be nigh):
This leads to the unwelcome conclusion that this crisis is more like the GFC than the dot.com bubble, even though there has been massive froth in a lot of tech names.
The same distinction between past big market events shows up once more when the exercise is repeated for correlation. More volatility tends to mean more correlation as everyone gets scared. That was most true for the Covid crisis. But the dot.com bubble saw far lower levels of correlation than might have been expected given the sharp rise in volatility. Sadly, as this selloff has been accompanied by surprisingly low volatility so far, it looks more like the Covid and Lehman crises, and less like the dot.com implosion. The market isn’t behaving as though one sector went bonkers and is now returning to its senses (even though something very much like that has indeed happened over the last 12 months). Instead, this is the kind of opportunity set we see during big systemic events:
How much do these things matter to active managers? Correlation naturally makes things harder for them, although not by as much as might be expected. In Degrees of Difficulty: Indications of Active Success, the index team at S&P Global sifts through the first two decades of their Spiva study, which compares funds’ performance to the index. This shows that the best managers do outperform the worst by more during periods of low correlation, as we might predict, but the relationship isn’t particularly strong:
Meanwhile the same exercise for dispersion reveals a clear link. Higher dispersion allows the best managers to outperform their peers, and hence also the index, by more; low dispersion makes it much harder for them:
S&P also found that conditions where large caps outperformed made life harder for active managers. The Twilight of the Fangs earlier this year, then, should also have helped stock pickers to outperform. Now, it could get harder.
The brutal bottom line: As it stands, this looks like it’s going to be a tough bear market for stock pickers to show their worth.
For dealing with inflation, here are some possibilities. Many moons ago, the great Victor Borge invented an “inflationary language”; more recently, John Oliver offered a less-profane-than-usual and actually quite balanced explanation; to scare yourself rigid, you could watch Ray Dalio on inflation; for a really good and meticulous exploration of the subject, listen to former colleagues Cardiff Garcia and Matt Klein talk about it on the New Bazaar podcast; and for a delightful analogy of the Federal Reserve to a therapist (I’ve cycled through a lot of analogies for central banking in my time and I’d never heard this one before), listen to former colleague Jeanna Smialek on The Daily by the New York Times. For the ultimate comic exposition of bodily inflation, nothing can beat Monty Python’s Mr. Creosote.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
John Authers is a senior editor for markets and Bloomberg Opinion columnist. A former chief markets commentator and editor of the Lex column at the Financial Times, he is author of “The Fearful Rise of Markets.”