Evaluating The Short Bond Trade

Three months ago, conditions lined up for us to think there was significant potential for a bond market sell-off, along with a steepening of the yield curve. That probability has largely borne out. Today, we take stock of the drivers of that move and provide our updated thoughts on the reward to risk of remaining short bonds from here.

Before we dive into positioning, we think it is important to frame how we think through the drivers. Treasury returns have two primary drivers: the policy rate and the shape of the yield curve. The policy rate has both a current impact, in that every asset’s return is relative to the short rate, along with an impact from expectations of the policy path over the security’s life. This component of Treasury returns typically has the most significant impact on fixed-income returns, particularly around economic cycle inflection points. The increased importance of short rates around economic cycle inflection points is largely due to policymakers using interest rates to cool and heat the economy.

When short rates are constant, the shape of the yield curve determines returns for Treasuries. This shape mainly depends upon the market-implied pricing of expected nominal GDP conditions, as allowed by the existing amount of liquidity available to purchase Treasury securities. As fixed-income instruments, the higher expectations of future nominal GDP, the higher long-term yields move relative to the short-rate, and vice versa. These nominal GDP considerations are not linearly priced into Treasury yields but serve as a rough intuition for the expectations priced into the Treasury curve. Additionally, this pricing is significantly impacted by the amount of liquidity available to purchase Treasuries across the curve- the less the liquidity, the higher yields are across the curve.

While many may focus on one component of this analysis, it is our view that having a comprehensive understanding of both parts of the bond yield and the factors driving each part is essential to have a durable edge in markets. Now that we have briefly introduced the drivers, we dive into each, beginning with the short rate.

Short rates are almost entirely a function of current policy and policy expectations. What drives moves in these markets are largely market participants’ assessments of current economic conditions relative to those that policymakers wish to achieve. Policymakers are largely trying to achieve a stable equilibrium between inflation and unemployment, where neither accelerates excessively. Additionally, there are many implicit concerns, such as real GDP and financial conditions. In the current context, policymakers have moved to tighten monetary policy to curtail inflation via dampening nominal spending. They have also moved to tighten financial conditions, with a somewhat more mixed impact. The Federal Reserve has been able to achieve a significant amount of tightening of policy rates without any meaningful change in unemployment. Furthermore, they have also been able to achieve a significant amount of disinflation, though trend rates of inflation remain broadly inconsistent with their mandate. Thus, there is little impetus to easy monetary policy, and there remains optionality to tighten further. Given that recent rates of inflation have moderated somewhat, we think that barring a meaningful reacceleration in inflationary pressures, it is quite likely that we are now approaching the local peak in policy rates. Inflationary pressures remain persistent, but we think it is increasingly likely that the Fed will soon begin to lean on extending the duration of tight monetary conditions rather than increasing their magnitude. We are watching this carefully. Now, this is the path of the realized short rate. Regarding expectations for policy rates, we see that the pricing has become far more reasonable than earlier this year. We have moved from pricing an extremely serious cutting cycle to a modest cutting cycle starting mid-year next year. While this outcome may not be realized, it is far less of a mispricing than we saw several months ago. Putting these two factors together, we think both the expected policy path and the current pricing of future policy rates now present a much less attractive opportunity set to be short treasuries.

Next, we turn to the shape of the curve, where we continue to see sustained pressures. As explained previously, the curve’s steepness contains information on nominal growth expectations facilitated by existing liquidity. Inverted curves are consistent with weak expectations for future nominal activity and a tightening of policy conditions. Based on our high-frequency tracking of economic conditions, the inversion of the curve year-to-date has largely been inconsistent with the ongoing clip of nominal GDP, making it unlikely that the poor nominal growth expectations priced into the curve are likely to be achieved or exceeded. Furthermore, we saw a significant chop in treasury markets despite there being a limited supply of Treasury duration. As duration supply came online, liquidity in the form of willing buyers remained limited; yields rose significantly. We expect more of both these forces likely to come, but to differing degrees. We think it unlikely that nominal GDP will be able to accelerate much further from here, which will likely catalyse further disappointments in economic data relative to expectations. We have begun to see the initial stages of these moves. However, we think that Treasury duration supply will likely remain a pressure on long-term bond prices, particularly following a debt-ceiling resolution. Weighing these impacts, we think nominal GDP dynamics will likely be neutral relative to the recent past, while increased bond supply will remain a catalyst for higher yields. Additionally, we think it is important to note that a significant reacceleration in fiscal spending finance by long-term bonds could potentially lead to substantial further steepening. Overall, we think that the drivers remain in place for more steepening, but much less so than previously.

Putting together our views on policy rates and the shape of the curve, we continue to think that Treasuries remain under pressure and are not a buy. However, the opportunity for short-side alpha has deteriorated significantly and expected returns on being short here are much less than earlier this year. As such, we think it prudent to take gains here and size down risk until meaningful mispricing presents itself. We continue to monitor the situation carefully. Until next time.