Here's What to Make of Bond Market Gyrations

The big news this week is obviously Pfizer's progress on a Covid-19 vaccine. For the fixed-income world, this has caused longer-term interest rates to jump higher. On Tuesday, the longer end of the curve hit fresh highs since the pandemic lockdowns began in March, with the 10-year Treasury closing Tuesday at 0.97% and the 30-year at 1.74%. This week's moves only add to what has been a volatile period for bonds. For most of October, Treasury rates were rising on the prospect of a so-called blue wave that improved the odds for fiscal stimulus. That thinking came crashing down last Wednesday when the wave never materialized, and the 10-year Treasury fell from 0.90% on Election Day to 0.76% the day after. What do we make of these gyrations? Could bonds finally be breaking out? Here are my thoughts on both what has happened and what to expect next. Rising rates are good news I find it helpful to think of every point on the yield curve as some combination of 1) expected Federal Reserve policy and 2) long-term growth and inflation expectations. The shorter the bond is, the more No. 1 dominates. For longer-term bonds, No. 2 is the more important factor. With this in mind, consider both the pre-election and post-vaccine push higher in bond yields. The two-year Treasury has hardly moved, trading in a range of 0.14% to 0.18% over the last month. Meanwhile, the 10-year Treasury started October at 0.68% and is now at 0.96%. So No. 1 (expected Fed policy) has hardly changed, while No, 2 (growth/inflation optimism) has moved meaningfully higher. At first it was hope for more fiscal stimulus, but then it was hope that humanity will triumph over disease. I have written previously that higher longer-term interest rates did not require a change in Fed policy or even actual inflation pushing higher. All it would take was optimism that growth and/or inflation could rebound. This is exactly what has happened. Between inflation and real growth, it looks like a bit of both are driving rates higher. The five-year TIPS level suggests the Consumer Price Index (CPI) will average 1.70% over the next five years, which is 20 basis points higher since quarter-end and the highest level since January. The 10-year TIPS break-even is 15 basis points higher since the start of October at 1.76%, highest since August. Meanwhile there has been almost no movement in fed funds futures. The December 2021 contract is trading at eight basis points. Fed funds currently is ... wait for it... eight basis points. So the rise in yields has been part a rise in growth expectations (i.e., real yields) and part an increase in expected inflation. It doesn't reflect any meaningful change in Fed expectations. Rising rates probably self-limiting We don't know how long this current selloff will last, but it is the rise that is probably self-limiting. First, the Fed isn't likely to hike interest rates until inflation becomes problematically high. We're pretty optimistic about employment growth, but even if recent strong trends continue the labor market is still probably a year or so away from being healed. The good news is the recovery is very fast compared to recent recessions, but it still leaves the Fed holding its target rate at zero for a long time to come. In addition, global interest rates remain extremely low, and that will act as a governor on U.S. rates. The U.S. 10-year will struggle to get to 1.5% or 2% unless global yields are also rising. For example, 10-year German Bunds yield -0.48% right now, which is only 4 basis points higher than Sept. 30, compared to nearly 30 basis points in the U.S. Those two rates can diverge to be sure, but there is a gravitational pull of global rates that will weigh on U.S. yields. Could the Fed intervene against rising yields? Could? Sure. Would? I doubt it. Higher long-term interest rates in response to positive economic news are just fine with the Fed. If rates were rising in an uncontrolled way or if the Treasury market became too illiquid to function, the Fed would ramp up quantitative easing (QE). Or, if shorter-term rates were rising in a way that was inconsistent with the Fed's own plans, that might prompt some action. As it is, don't expect the Fed to lean against rising yields. Besides, QE doesn't work anyway. Low-quality rally in credit The other big news was in credit markets. High-yield bonds soared on Monday, with the Barclays High-Yield index jumping 1.1%. The lowest quality bonds led the way, with CCC-rated bonds up 1.7% vs. just 1.0% for BB/B-rated names. Even that probably doesn't tell the story. Here are the top five industry performers in the junk bond index on Monday. I've also noted the biggest single performer in each: Airlines: 3.9% (American Airlines +13.0%) Leisure: 3.8% (AMC Entertainment Holdings +25.1%) Refining: 3.5% (PBF Energy +11.9%) Retail REITs: 3.4% (Brookfield +5.0%) Independent Energy: 2.5% (Laredo +20.1%) It is reasonable that definitive news on a vaccine is important news for these companies. For a company such as AMC , some visibility as to when movie theaters will be open again makes it a lot easier for them to raise capital. Indeed, American Airlines and Carnival Corp. both announced equity offerings this week, taking advantage of higher share prices. That's the kind of thing that can save a company with a weak credit profile. Even those that can't raise fresh equity are going to find themselves in a much better position. Lenders rarely want to put a company in bankruptcy. Readers may have heard of the phrase extend and pretend. That is a banking practice where lenders will roll over existing debts for a very shaky borrower, hoping that the new financing can bridge the borrower to a time when they can afford their debt service. This vaccine news is a perfect excuse for lenders to extend and pretend for borrowers in the most impacted industries. Generally speaking, junk bonds are a momentum market, but this week's rally has resulted in the absolute yield of the high-yield market at all-time lows. Given that junk bonds have been extremely correlated with value stocks this year, it sure seems like buying a basket of value has much more upside than piling into junk bonds here. I'm not particularly bearish on high-yield here, but your upside is probably just that yield. Unless you can pick your own positions, there are probably better places to put your capital.

Here's What to Make of Bond Market Gyrations

There also are multiple ways to look at what to expect next from Treasuries and junk bonds and how to act accordingly.

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