Charts of the Week: The Bond Bear Market

We’re experiencing one of the most prolific and sharp bear markets that US Treasury bonds have faced in their entire history. If 2023 closes out with another loss, then it will mark the first time in history that US sovereign duration fell for three years in a row.

These losses are a concern as they are forcing up rates not just in the US, but around the world and in a variety of credit instruments. Increasing pressure as the cost of capital rises.

Brutal Bond Blowout Bursts Bubble as Bears Bite

Barclays analysts have stated that only a “stocks crash” can rescue the bond market. While that may or may not be true, it is certainly an interesting take to consider in the near-term as the “recession rotation” trade backfired spectacularly for bond longs over the last several months. Leaving many longs wounded and gun shy.

The impacts of this global surge in rates have been felt far and wide, with longer duration debt hit the hardest. A stunning example is the 75% decline in Austrian 100-year bonds that mature in 2117. The bond has a mere 2.1% coupon, and heralds back to an era of global zero and even negative interest rate policy. An era that now seems like a distant memory.

Rates are Rocketing Higher Globally

This rise in global rates, based on the 1-year change in median 10-year government rates, has been the fastest ever. That’s a big deal. Not only because of the amount of change, but the velocity. Meaning that there really will be greater lagged impacts from this passing into a variety of credit and other risk markets over time as debt is refinanced and new debt is issued.

This surge in global rates has appreciated the cost of capital enough that it is quite likely to slow global economic activity as well. Particularly from more leveraged businesses and consumers that may no longer have the budgetary elasticity to participate at the level they had.

We’ve certainly seen signs of consumers pulling back, for example, as they spent less in September, with consumer credit falling by amount as much as it was expected to have risen.

Regional Banking Risks on the Rise

Banks are also taking a hit, again, as their unrealized losses are likely to increase appreciably over Q3 due to the rise in rates on their HTM and MTM securities as well as loan books. This may hit regionals the hardest.

Rising Real Rates Often Break Something

As real rates rise (or the difference between nominal rates and inflation) into positivity, that often causes some meaningful harm for financial assets. Examples include the dot com bust and subprime collapse, as well as the rally in biotech vs broader long duration risk. What might take a hit this time?

Bond Buyers Remain Bullish

Even with all of this pain in bond markets, there is a rather significant bid into Treasuries this year, particularly on the shorter end. Annual flows may be set for their steepest surge ever, as a part of the “Great Rotation” theme that has more savers and retirees putting funds into Treasuries than equities as the TINA trade era ends and we see fixed income provide viable alternative, particularly within shorter duration low risk paper.

Hard Landing in Housing Coming?

Surging rates have also had a rather sizable impact on the US housing market, with existing home sales collapsing, and rates rising to the highest level that we’ve seen since 2000 recently. Those rising rates put pressure on mortgage applications, as less buyers are able to afford a home with this cost of capital.

Those mortgage applications are at lows we haven’t seen since 1995. Meanwhile, existing owners aren’t tempted to sell because nobody wants to go from around 3% to more than double that.

A telling example is below. If one was getting a loan for $399,999 in 2021 vs 2023. The difference in the total cost of the loan is remarkable, and something that precludes many buyers from participating in this market due to a combination of high home prices, high rates, and an overall cost of living that has surged over the last several years due to inflation.

Some have resorted to staying in “pods” within some of the more expensive regions, like San Francisco. An incredibly telling trend that suggests younger generations, where about 50% of 18-29 year olds live with family, are locked out of the housing market completely. Even for renting in more expensive areas.

In greater California, 34% of residents say they are considering moving due to housing costs.

Oil Isn’t Going Away Anytime Soon

If anything, quite the opposite as we see energy scarcity becoming a theme and therefore the role that oil plays within industrialized civilization becomes ever more critical as price is likely to rise significantly without increases in production and discoveries.

Oil is also used in just about every part of our lives, whether it is transportation, growing food, heating, plastics, asphalt, chemicals, and much more.

Exxon’s purchase of pioneer resources, which is a large Permian shale oil and gas producer, illustrates the confidence of a major energy player in the future of oil and its importance as a source of energy.

Liquidity and Volatility

We’re seeing order book depth in the S&P 500 futures drop. This tends to lead to higher levels of volatility as it takes less volume to move price more.

We can see that less order book depth leads to higher VIX and vice versa, based on this study, which tells us that as long as liquidity remains low we may see volatility remain elevated compared to what we’ve seen up until recently.

There is another consideration, however, and that is seasonality. Which implies that volatility has room to rise before it ultimately collapses into positive stock market seasonality from Mid-October through December.

Consumers are Slowing Spending

The data we’re getting in from September suggests that US consumers slowed spending meaningfully. Consumer credit fell about as much as it was expected to rise and credit card spending led the drop.

With rates rising and excess savings running out, we’re seeing signs that the consumer is slowing meaningfully build up.

One of those signs is how much spending plans over the next six months show that respondents are showing that they want to spend less on discretionary items, especially consumer electronics, small appliances, toys, and leisure/entertainment activities.

We’re already seeing this show up in the data, with electronics and household appliances leading the way lower in consumer spending.

Closing Thoughts

There are increasing signs of stress in the economy and within housing, bond markets and that may be an early sign that we’re due for a broader slowdown and perhaps more corrective pressure within duration and risk assets.

While positioning suggests that the current rally may be able to run further, that could present an opportunity to reduce or at least hedge risk.

We’re also continuing to favor more defensive allocations, such as Treasury bills, low beta high dividend large caps, cybersecurity stocks with defensible competitive advantages and commodities where supply and demand dynamics and price momentum make them favorable allocations.

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