Bond market explainer series : why did bond yield spike, what is happening behind the bond-selloff ? How did it cause the market turbulence ?
As promised a few days ago, in this article, I will do a deeper dive into bond market because it’s the ground zero for the market tumult for 2022 – 2023, especially in the month of august – September where 10-year yield spike to a high of 4.88%.
Basically, you can stick any superlatives label on bond market and it will probably stick, it has become the new American horror story.
10 year bond lost so much value , you will have to go back to the 18th century, since the bond first invented to find a comparison ( in % term ).
The volatility of bond is measured in MOVE index, it reached a high of 160 in 2022 and 200 in 2023, meaning the bond was expected to have annual price movement of 16% -20% ( in contrast to the usual 70-80 in MOVE index , meaning 7-8% annual price movement ) , making it as volatile as stock price.
Inherently, longer duration bond ( 10 years or longer ) is more prone to greater duration risk due to interest rate fluctuation ( compared to shorter duration bond ), therefore longer duration bond price would drop more if rate expectation is higher.
As shown by the following 3 charts,
IEI (3-7 year treasury bond ETF ) , from peak to trough , it lost 14.7%
IEF (7-10 year treasury bond ETF ) , from peak to trough , it lost 23.4%
TLT (20+ year treasury bond ETF ) , from peak to trough , it lost close to 50%
In the year 2022 context, Bond yield was high because we have high inflation worry, and fed chairman Powell went Full-on Volcker mode in busting inflation, during his 2022 Jackson Hole speech.
But in year 2023, 10-year yield spiking higher ( July - Sept) even though inflation is subsiding ( CPI has declined from 6% ish to 3% ish, PCE decline from 5% ish to 3% ish, in the past 10 months), so why is this conundrum happening ? ( 2023 10 year yield higher than 2022 10-eyar yield ). Some financial media attribute it to Fed high for longer rhetoric in September fed meeting, still-high inflation, crude oil is still at 90’s dollar per barrel. ( in other words interest rate expectation ). Is there something else happening behind the scene that could provide a more convincing explanation ?
To explain this phenomena, I have to lean on research from CrossBorder capital, because their excellent research has shown some interesting insights.
Fundamentally, Bond yield can be broken down into 2 parts ( economics textbook definition ),
1) Interest rate expectation
2) Term premia (term premium)
What is term premia, it is the amount by which the yield on a long-term bond is greater than the yield on shorter-term bonds, this yield is the compensation that investors require for bearing the risk that interest rates may change over the duration of bond
For year 2022, much of the increase bond yield can be attributed to interest rate expectation ( fed rate hike expectation and terminal fed fund rate )
But in year 2023, something different happen,
During January – June 2023, 10-year yield can largely be explained by terminal policy rate.
But during July to September, 10year yield is largely attributed to rise in term premia.
So why is term premia increasing ?
i)Supply-Demand imbalance
1) Supply is increasing ( treasury issuance increase )
US Government was not able to issue treasury debt before the debt ceiling was raised, and could only start issuing Treasury in Q3.
2) Foreign (& domestic commercial bank ) Demand is falling
As shown in chart above, Treasury issuance is 2nd highest since 2020 ( and highest if we account for net buying/selling purchase of treasury from Fed and Treasury cash balance)
The treasury supply qty is extremely huge in Q3, making it difficult for Japan and china to absorb it even in normal environment, it’s worse under current challenging environment where Japan and China had to defend their currency in the face of strong US dollar - sell US dollar / sell Treasury in order to sell US Dollar from Treasury proceed.
Domestically, US bank is trying to reduce Bond duration risk, lest they suffer the fate of SVB. ( in contrast to the previous years where they were the huge net buyers due to Basel III requirement )
ii)Central bank liquidity provision
FED is reducing their balance sheet size in their so called “Quantitative tightening” (QT) .while japan is loosening their yield curve control, causing Japan 10 year yield to increase from 0.4-0.5% to 0.8% ( 60% increase ). Globally, Bond market are highly correlated, so if Japan/UK Gilt/German bund yield are rising, US bond yield will rise together.
As a result of the above factors, bond buyers are moving from price insensitive buyers ( Fed, Foreign Central bank, US commercial bank ) to Price sensitive buyer ( Asset managers, Pension fund, Hedge Fund ), these group of price-sensitive buyers demand (big) discount in the face of huge supply of bond, causing the bond price to fall, further increasing bond yield ( & increasing term premia ),
So with the recent rising bond yield ( and rising Term Premia ), what are the implications for Economy or stock market ?
The short answer :
Economy – Re-steepening of yield curve, growth and inflation is expected to be higher than previous decade, personally I think there will be more growth but subjected to bouts of benign inflation or higher-than-usual inflation. In case you don’t know, some media / analyst dub as the new recession signal, Bond yield invert and the un-invert through steeping of yield curve, I am not convinced at this argument, which I will talk about in part 2 of the bond market explainer series .
Stock market – Stock fall as liquidity is decreasing in July – September during bond yield spike ( MOVE index increase from 100 – a high of 140 in the same period, market demand bigger haircut to bond collateral and reduce market liquidity as a result, stock price usually fall when MOVE is going up )
How will the bond yield episode evolve going forward ?
To quote a famous market analyst, Bob Farrell,
Source : https://school.stockcharts.com/doku.php?id=overview:bob_farrell_10_rules
In the next 2 articles,
1) Bond market explainer series part 2 – why the much-anticipated 2023 recession did not happen ?
2) US stock market review
Disclaimer : The information presented here are for research and education purpose only, and does not constitute investment advice, trading recommendation, author shall not liable for any action taken by any individual/company with regards to the information presented here or any part of the website - https://marketcycleedge.substack.com/