Monday May 11, 2015 | David C. Wright & Frank A. Barbera
An unusual surge occurred in the yields of U.S. and other major industrialized countries’ high-grade bonds early in May. It began with spikes in European bonds led by a weaker German Bund, which ballooned from 5 basis points to a recent high near 78 basis points. The jump in German Bund yields, along with those of Italy, Spain, and Portugal, came amid widening credit default swap spreads and negative comments from bond market luminaries Bill Gross of Janus and Jeffery Gundlach of DoubleLine.
In what appears to have been a crowded trade, the rapid unwinding of highly leveraged positions produced a mechanical margin call, of sorts, that rumbled across the global bond market. This involuntary deleveraging was not produced by any specific news event or economic announcement, but looks to have arisen primarily from thin market conditions and was triggered when large players started looking for the exits and found liquidity scarce, triggering an arbitrage event and causing yields of U.S. Treasury debt to rise.
Over the last few months, bond market liquidity has been declining notably after central banks bought up large amounts of government debt, crowding out other buyers. While governments are still actively experimenting with numerous types of stimulus programs, it appears they have surpassed the point of diminishing returns and, as a result, the trend for yields remains down.
An additional aspect of the yield spike may have been a multi-week series of economic data points in Europe that have been improving moderately, taking some of the fear away from what was perceived to be an accelerating deflationary trend. As deflationary fears eased, yields began to advance.
As illustrated below, the domestic long-term bond yield remains well below its 100 month moving average. Thus far, the recent rise in yields is nothing out of the ordinary and is still a long way from any significant secular trend change signal.
The yield on the 10-year Treasury note is considered to be the fulcrum against which major investors around the world price other bonds, adding a risk premium depending on the type of bond. (Risk premia in turn fluctuate, depending on supply and demand of the specific bond types and trends in global attitudes toward economic and default risk.)
We believe the recent upward reaction in yields will prove to be transitory, and for at least the short-term, yields around the globe could continue to trend lower.
The surge in yields has so far lasted 16 trading days, and has taken the 10-year Treasury yield from 1.87% to 2.25%, an unusually high move in yields in terms of magnitude and speed, particularly for a rising yield sequence.
This episode has led to price declines in some U.S. Treasury bond correlated holdings to sufficiently hit our stop; resulting in the temporary selling of these holdings.
We remain highly focused on studying data that will help us understand whether this trend is indicative of a sustained new focus of large institutional investors around the world. Rising interest rates typically occur when market participants expect a tightening by the Fed, a surge in inflation, or the sudden end of some factor that had previously worried the global markets. (The latter would occur only after an obvious fear episode had taken yields down; not the case here.)