The Danger of a Severe Recession is Being Overplayed by the Bond Market
- Trade in other significant markets implies that contrary to what Treasury investors believe, a terrible economic slump is not as certain.
The bond market responded strongly as banks began to fail. On three days in March, two-year Treasury rates decreased by one percentage point, which was the greatest since 1982.
The message was clear to traders who are used to viewing such indications as sacred. The day when inflation was their major threat is long gone. Rates indicated that banking system stress had made a recession imminent.
Or did they not? Three weeks later, there are still unanswered issues regarding fixed-income volatility, which, despite its ferocity, is mostly absent in stocks and credit.
Given the influence Treasuries have in models created to predict future inflation and Federal Reserve policies, explaining the gap has been a Wall Street preoccupation. One question is whether factors unrelated to the economy—in particular, pessimistic posture among speculators—made the sharp decline in yields a recessionary false alarm.
According to Bob Elliott, a chief investment officer of Unlimited Funds and a former 13-year Bridgewater Associates employee, "The present pricing doesn't make sense, but it's going to take a long." "Each day without a financial crisis is another day that shows the existing pricing is illogical,"
The argument is far from decided, as is customary in markets, and the sudden jump in rates may wind up being what it typically is: a dire indicator of the state of the economy. While there are still pockets of calm, markets are still far from signaling the all-clear. Their substantial reductions in value from the previous year and the dominance of mega-cap technology shares at the top of the 2023 leaderboard might be seen as warning signs of disaster. Corporate credit has kinks that are similar to these.
Even still, the disparity between the market's responses to the events of March continues to be historic level. The stock market, which is typically a place for speculators to act quickly and with a shaky grasp of larger implications, handled Silicon Valley Bank's collapse and the ensuing worries of contagion quite well. Blue-chip and high-yield spreads in credit have never been larger than they were last October.
In the meanwhile, last month saw the largest daily swings in two-year Treasury rates in forty years. Midway through March, the ICE BofA MOVE Index, which measures one-month options' estimates of anticipated swings in Treasury prices, surged to its highest level since 2008, creating the largest disparity between stock and bond volatility in 15 years. The gauge is still higher than usual compared to the prior ten years' average even after things have cooled down a little.
Such severe repricing would typically be one of the greatest indicators that a recession is about to begin. According to George Pearkes of Bespoke Investment Group, the meaning is less clear as of right now.
The company's global macro strategist, Pearkes, claims that although the Treasury market isn't constantly trading in full panic mode, it doesn't suggest that what is now reflected in the price is some sort of precognitive, "This is how to think about it," signal. The prices are far too cheap. We haven't seen any signs that the deposit flight narrative has expanded to the credit markets or the wider banking sector, except for a few regional banks.
As Dominique Dwor-Frecaut, a senior market strategist at the research company Macro Hive Ltd. and a former member of the New York Fed's markets group, puts it: "The bond market has gone insane." "For once, I'm with the stock market. I don't anticipate a recession.
The fixed-income group, long seen as the more shrewdly invested among asset classes, will take offense at any insinuation that stock jocks had a superior grasp on the events of the last month. However, the notion is supported by positioning data. Following the losses of last year, overall long exposure among asset managers was close to the lowest level in a decade. Equity hedge funds spent the nine weeks before the SVB blowup cutting bank shares.
Bond dealers were exposed by the early March establishment of the $24 trillion Treasuries market. Models from Citigroup Inc. and data from the Commodities Futures Trading Commission revealed that, before Silicon Valley Bank's abrupt collapse, bets against two-year Treasuries had soared to record heights, crushing hedge funds and speculators as markets sharply revised Fed forecasts.
It's too soon to be optimistic after the collapse of three banks and the government-sponsored bailout of a fourth in Europe less than a month ago, even if Treasury Secretary Janet Yellen claims the system is beginning to stabilize. The VIX, the benchmark for equities volatility, and the MOVE index occasionally flash divergent signals, but history suggests that this doesn't continue, according to Harley Bassman, the former Merrill managing director who invented the MOVE index in 1994.
According to Bassman, managing partner of Simplify Asset Management Inc., the VIX will ultimately increase. The yield curve's structure, credit spreads, and implied volatility—by which I mean any measure of volatility, including the VIX and MOVE—have all shown a significant correlation over the past thirty years. Over time, all of the risk metrics show a significant association.
Bond short-covering was tough due to the difficult trading environment. Amid the pandemonium, the bond market's already precarious liquidity got even worse after declining for months. Even more unusual activity was suspended in a crucial area of the rates market as a result of the violence, which exacerbated price movements.
The market is quite unpredictable. This makes me think of the illiquidity of the bond market in 2008–2009. It's sufficiently alike. Vineer Bhansali, founder of LongTail Alpha LLC and former head of analytics for portfolio management at Pacific Investment Management Co., emphasized that you cannot afford to be caught in a terrible scenario. Right now, the Treasuries market looks like a roach motel. There is a door but no way out. then proceed with extreme caution.
Even when volatility declines, the departure rush has left a gaping imprint on the charts. Even if recent days have seen a return to more regular pricing behavior, two-year Treasury rates are still much lower than they were at the beginning of March. Even if bond traders pull off on the most dramatic pricing for Fed rate reduction, yields are still stuck around levels hit in the wake of SVB's collapse.
The question is which managers are prepared to intervene and short the bond market once more following such a ferocious flush-out. Investors have gone to the other side of that trade, according to data from Citi, which shows that traders have substantially covered their short positions in front-end bonds while switching to a bullish position in other curve segments.
According to Unlimited's Elliott, it may take months for the significant disconnects between Treasuries, equities, and credit to normalize while macro managers "lick their wounds." Yet when worries about the state of the banking sector wane, the temptation to intervene will grow.
Regardless of the price, it is doubtful that the macro funds, which were designed for higher returns over a longer period, will begin to leverage again. Elliott said that it had only caused them damage. Until investors who were previously short the two-year feel secure enough to start selling their holdings once again, a few data points will be required.
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