What Bonds Are Telling Us Now and Why I'm Eyeing Financials Again

Treasuries remain dull. The 10-year closed every single night last week at either 0.62% or 0.63%. While a barrage of data hit the tapes, while we had an ECB press conference, while the Nasdaq 100 was whipping around all day long, Treasuries did next to nothing. I continue to see Treasuries reacting rationally to the current market environment. Here's why: The Fed is going to ease monetary policy faster than they will tighten it, keeping the front-end of the yield curve anchored at nearly zero, which in turn, supports the entire bond market. The Fed has made it clear they would like to avoid negative rates. With the 2-year trading at 15 basis points and the 5-year at 28 bps, it is hard to get to significantly lower yields if you think the Fed will avoid negative rates (which is the reasonable base case). The Fed will buy bonds if needed and the Fed will implement yield curve controls (YCC) before negative rates. If you believe this, and I do, since it is what they are telling us they will do, then the long end of the bond market will remain well bid. Yes, YCC is likely to start with the 2-year to 5-year maturity spectrum, but that will impact the 10-year as surely as night follows day. So, the bond market is not pricing in doom and gloom for the economy, it is just pricing in the Fed's reaction functions. Curve Steepness Is Interesting (and a Positive) I like that the spread between the 2s vs 10s has settled in around 50 bps. Part of the reason, I believe, that the Fed wants to avoid negative yields is because many people think negative yields hurt banks, which in turn hurts the entire economy. So, it would be logical to assume, that even in a world of YCC, the Fed would want to leave some steepness in the yield curve, which in theory helps financials. No one seems to be talking anything positive about banks, but this is a minor positive. Credit spreads tightened marginally (2 bps on CDX IG and 7 bps on Bloomberg Corporate OAS) with investment grade basically tracking the S&P 500 and high yield more correlated with the Russell 2000. A smaller new issue calendar also helped, as only $13 billion of IG was issued last week. Expect the stock market and credit spreads to remain correlated in the coming weeks. The one thing that I think needs to happen for credit spreads to move materially tighter is for banks to take the lead. JPMorgan Chase CDS, for example, is in the mid 50's, down from its peak of 150, but still well above the 30 bps it was trading at for much of 2019 and the start of 2020. Bank credit spreads are a key driver, because not only does it affect their profitability, but it tends to correlate with willingness to lend. The tighter bank credit spreads are, the better for the credit markets and the economy. Financial Stocks Continue to Struggle - But Should They? Financial Select Sector SPDR Fund , a financials ETF, remains 10% below its June peak, 22% below it February highs and 14% below where it was a year ago. We can get these disconnects for periods of time. The economy, especially the tech-driven economy, can do well without financials to some extent, but if the problems plaguing banks (or at least the problems investors think are plaguing banks) are real, then it will be difficult for stocks to continue their rally. If the problems aren't real, or are overly priced in (the direction I'm leaning), then banks and financials in general need to outperform. What to Make of Commercial Real Estate and Delinquencies Payment delinquencies. From mortgages to rent, from commercial to residential, there is story after story about high delinquencies. But, often, only buried deep in the article and away from the gloomy headlines, are facts about forced forbearance. If a tree falls in a forest, does it make a sound? If someone skips a payment they aren't obligated to make, did they miss a payment? Understanding which payments are going to be permanently impaired is crucial to getting this market right. Determining how severe any restructuring efforts will be (i.e. does only the equity holder lose or will creditors be significantly impaired?). Given the reserves we've seen taken by some banks, have they already protected themselves from something worse than the reality will be? I am struggling to get a grip on just how bad delinquencies are across various products. As I start digging into this, and it is very preliminary so far, as it isn't part of the data I routinely examine, my best estimate is that investors are being too fearful on a lot of things that have the potential to be delinquent -- with commercial real estate high on that list. If commercial real estate is being viewed too pessimistically (another sector, like banks, that is well below its June highs), then not only is that an opportunity, but it would bode well for financials, which are being dinged for these exposures. Think Financials While I'm not quite to the pound-the-table level of bullishness on financials, they keep popping up in my scenario analysis as having the least downside in many of my bearish scenarios and the most upside in my bullish scenarios -- which basically means, they seem to have the best risk/reward from a trading standpoint here. Bottom Line I am still bearish on risk, expect the reversal that started last week to continue, and think bonds will remain dull, with high yield most susceptible to a pull back.

What Bonds Are Telling Us Now and Why I'm Eyeing Financials Again

Financial stocks continue to struggle. But should they?

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