The bond market is exaggerating the risk of a deep recession

For traders accustomed to holding such signals sacred, the message was clear. Gone are the days when inflation was their main threat. Rates showed that stress in the financial system made a recession inevitable.

or did they? Three weeks later, questions about what to do with fixed-income volatility won’t stop swirling, as its ferocity remains mostly absent in equities and credit.

Explaining the divide has become a Wall Street obsession – a must, given that Treasuries are dominated by models designed for the divide. future of Inflation and Federal Reserve Policy. One concern is whether a large decline in yields that has nothing to do with the economy — bearish sentiment among speculators, in particular — is a bearish false alarm.

Bob Elliott, chief investment officer at Unlimited Funds, who works for Bridgewater Associates, said, “Every day when there isn’t a banking crisis is another day indicating that current pricing doesn’t make sense, but it will take some time.” It’s going to take.” for 13 years.

As always in the markets, the debate is far from settled, and a fall in yields could be just what it usually is: a grim sign for the future of the economy. While things are currently at peace, stocks themselves are far from looking entirely in the clear. Their big drop last year, and the dominance of megacap technology stocks atop the 2023 leader board, can be seen as part of the trouble. Similar wrinkles exist in corporate credit.

Nevertheless, the divergence in market reactions to the events of March remains at a historic range. The stock market, typically a realm for shoot-first speculators whose grasp of big-picture meanings may be tenuous, absorbed the Silicon Valley bank collapse and fears of contagion that followed with relative ease. In credit, blue-chip and high-yield spreads have never been wider than levels in the last decline.

Meanwhile, the daily volatility in the two-year Treasury yield soared last month to the most in 40 years. The ICE BofA Move Index, which tracks expected volatility in Treasuries as measured by one-month options, climbed in mid-March to its highest level since 2008, as well as in 15 years amid stock and bond volatility The biggest gap opened. Even after things have calmed down a bit, the gauge remains at more than double its average over the past decade.

In normal times, such a violent revaluation would be one of the strongest signals the market could send that a recession is coming. According to George Pirks of Bespoke Investment Group, the explanation is less clear right now.

“The Treasury market isn’t trading in pure fear mode every moment, but that doesn’t mean that what’s currently priced in is some sort of a signal, a ‘how to think about this’ signal,” said the firm’s Pearce. said the global macro strategist. “Rates are very low. We have not seen signs of the deposit flight story wider metastasizing into credit markets in the broader banking sector, apart from a few regional banks.”

Stated differently: “The bond market has gone berserk,” says Dominique Dvor-Frecot, a senior market strategist at research firm Macro Hive Ltd., who previously worked in the New York Fed’s markets group. “For once, I’m on the side of the equity markets. I don’t see a recession coming.”

Any suggestion stock jocks had a better handle on the events of the past month would rankle the fixed-income set, which has long been seen as the better wealth among asset classes. But the positioning data supports visualization. Equity hedge funds spent nine weeks ago svb The blowup was trimming bank shares and, on balance, long exposures among asset managers were near their lowest levels in a decade after last year’s drubbing.

Meanwhile, a $24 trillion Treasury market formation in early March made bond traders weak. Citigroup Inc. Models and Commodity Futures Trading Commission data showed bets against two-year Treasuries climbed to record highs before the Silicon Valley bank’s sudden collapse, spurring hedge funds and speculators as markets dramatically recalibrated Fed expectations. Did.

Of course, with three bank failures and a quarter in Europe less than a month from government-sponsored bailouts, it’s too early for optimism, even as Treasury Secretary Janet Yellen says the system is showing signs of stabilization. Used to be. Harley Bassman, a former managing director at Merrill who created the MOVE index in 1994, said it’s not unusual for the VIX — the equity volatility benchmark — and MOVE to flash various signals, but history shows it doesn’t stick.

“It’s only a matter of time until the VIX picks up,” said Bassman, who is a managing partner at Simplified. asset Management Inc. “Over the past thirty years we have seen large correlations between the shape of the yield curve, the credit one implied volatility spread – and I mean all volatility measures including the VIX and MOVE. The whole pack of risk metrics are highly correlated over the long term.”

Short-covering in bonds was made more painful by tight trading conditions. The already thin liquidity situation in the bond market worsened after months of poor liquidity. The violence also halted a rare trade in a key corner of the rates market as volatility increased, fueling volatility in prices.

“The market is extremely illiquid. It reminds me of the illiquidity in the bond markets in 2008-09. It is similar. Vinir Bhansali, founder of Longtail Alpha LLC and former head of analytics for portfolio management at Pacific Investment Management Company, said, “The Treasury Market is a roach motel right now. You can get in. But you can’t get out. So be very careful.”

Despite low volatility, the rush to exit has left a gap in the charts. Although a semblance of normal price action has returned in recent days, the two-year Treasury yield is more than a full percentage point lower than it was entering March. Yields have still reached post-SVB implosion levels, even as bond traders ease into the most dramatic pricing for Fed rate cuts.

But after such a violent flush-out, the question becomes which managers are ready to step in and short the bond market again. In fact, investors have swung in the opposite direction of that trade: Data from Citi shows that speculators have largely covered their shorts on front-end bonds, while parts of the position curve are in bullish territory. Flipped.

Large dislocations between stocks and credit Treasuries could take months to heal as macro managers “lick their wounds,” according to Unlimited’s Elliott. But as concerns over the health of the banking industry continue, it will become more and more tempting to intervene.

“Macro funds that were positioned for higher-longs are unlikely to start taking advantage of the back up, regardless of pricing. Elliott said, “They just got burned by it.”

The text of this story is published from a wire agency feed without any modification.