Three months ago, in ‘Inflation Hyperventilation’, we questioned the prevailing narrative of higher bond yields, bear steepening, a secular inflation breakout, and a sustained boom in growth amid the end of the pandemic. Since then, 10-year Treasury yields have fallen by 25 bps (more versus the forwards), and the US 5s30s curve has flattened by 35 bps. Coming into 2021, we noted in ‘Just another range trade’ that both the sell-side and buy-side consensus was more concentrated than in any year we could remember. That consensus may come under further pressure, as the same pain trade that hurt those in bear steepeners over the past three months still looks crowded.
Harvard and Cornell University psychologists Christopher Chabris and Daniel Simons famously showed in their ‘Invisible Gorilla experiment’ the role of selective attention – or tunnel vision – in cognitive information filtering. In bond markets today, tunnel vision seems prominent with many overly focused on their priors, rather than considering the idea that other drivers may come to the fore.
What matters from personal experience doesn’t necessarily matter economy-wide
For example, many finance professionals see evidence of higher economy-wide inflation from their personal spending experiences, even though their own CPI baskets sit in the top 1% of income cohorts. Furthermore, home prices in desirable locations are up 10-20% in many economies, yet rents chug along at 2-3%. Used cars, which outsell new cars by 3:1 in volume terms in the US, have seen price falls for three months now – a key indicator given its contribution to year-on-year CPI data in the spring. What market professionals notice from their personal experience is not necessarily what will matter economy-wide.
Second, many investors take a cyclical view, when more secular-oriented economists, such as HSBC’s Stephen King and Morgan Stanley’s Seth Carpenter, have recently pointed out there are evident two-way risks to inflation.
Third, on valuations, some investors still cling to a link between nominal GDP and bond yields, even though nothing other than supposition suggests this is required. It may have worked well in the 1980s and 1990s in developed markets (DM), yet it has failed spectacularly in increasingly internationalized markets since 2011, and failed once again in the most recent three months. More surprisingly, many look at nominal GDP for 2021 or 2022 and compare it to yields of 30-year bonds (maturing in H2 2051), suggesting there should be some relationship. Yet if the Fed does not raise rates until Q4 2022 (from 0.25% to 0.50%), the nominal GDP of the next 12 months is simply irrelevant, in direct terms, to the bootstrap mathematical pricing of bond yields. Others point to low real yields and yet, as HSBC’s Steven Major has pointed out, they are simply a residual of central bank-influenced nominal yields and market-implied inflation expectations. The commentariat is drawn to yield direction, when the bigger moves are in curves. (The lessons of the 2005 conundrum, of curve behavior early on in an expansion, appear to have been forgotten.) On tenors, many look at the 10-year segment, when the more pronounced price action in the US has been 5s30s flattening and the asymmetry on the short side is in 2s. Many focus on US yields, when capital gain opportunities look much more attractive in China. On the short side, there is arguably more asymmetry in Germany. Non-US cross-market looks the best fixed income trade to us from here.
Tunnel vision on tapering
Fourth, on policy, there is tunnel vision on tapering: our analysis shows the impact is divergent on real yields and breakevens, yet the consensus focuses on nominals. The taper question, a serious topic back in March, now looks like yesterday’s news: it has been far more widely flagged than 2013. Where will the surprise be? Markets should broaden their surveillance on policy: brink(wo)manship on the upcoming debt ceiling, the German election and China property tightening may be more influential.
Finally on the virus, the market assumes a ‘back to normal’ situation within a couple of months, despite evidence from Israel, Scotland and Florida, among others, that this is far from assured. Observations are often made at the country level, when patterns that may portend more are regional, particularly given the staggered schedule of back-to-school dates. We have seen a virus flare at the start of the past three school terms. Alternatively, the virus might peter out in DM in a couple of weeks, or it might be a tough winter. But who could honestly place a sensible bet on each outcome? The travails of recent forecasting at Imperial College London show just how careful even professional epidemiologists need to be in distinguishing possibilities from probabilities. Yet there is evident bias in the consensus approach: we count 12 times in the past 18 months when a ‘back to normal’ assumption has dominated, only to be upended.
All in, the bond community, it seems, has become selective in its attention, resolute in holding its priors, narrow on the geographic opportunity set, stale on policy focus and lacking in a cohort-based approach to household balance sheet analysis. There is plenty of positional evidence of herding and groupthink, with few apparent lessons learned from Kindleberger.
To be sure, the risks are not one-way. We think a broader range of scenarios is more appropriate. Nominal Bund yields may yet rise amid upcoming German elections. Globally, the ongoing manufacturing pipeline and inventory restocking may be powerful. Leisure and hospitality wages are rising sharply.
The bond community, it seems, has become selective in its attention, resolute in holding its priors, narrow on the geographic opportunity set, and stale on policy focus.
Staying focused on valuations and positioning
We prefer to stick to our contrarian and value-led philosophy, which means a focus on valuations and positioning. We are weary of bear steepeners in the US. In Bunds, there is a bit more valuation asymmetry to justify a short, at least when 10-year yields are close to the depo rate. But we think there are more interesting risk-return trades than simply directional selling of Bund futures.
In credit, we see little scope for capital gain with many high yield (HY) issues trading to call. However, we think EUR investment grade (IG) remains the best protected amid ongoing ECB buying. Moreover, swap spreads have some narrowing potential. The biggest questions, highlighted by pronounced volatility across both IG financials and HY property since April, are in China credit.
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