Bond Investors, Look Out... A Reversal Is Coming

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Summary

A bear steepening movement in US bonds has started.

Domestic political and global macro factors could fuel the extension of this steepening move.

Bond investors could be surprised as they are too complacent and do not expect an imminent burst in price/yield volatility.

US bond yields, as well as the shape of their curve, have been exhibiting erratic swings lately. This puts the bond bubble (NYSEARCA:TLT) to the test. Will bond yields be dragged down to new historical lows, inflating this bubble even more, or are they ready to unleash a big reversal to the upside? Judging from a series of underlying macroeconomic and technical indications there is an increased probability for bond yields to rise, especially the long-term ones in relation to the short-term ones. This bear steepening debasement of the yield curve, which according to some technical indications, has actually already begun, can produce some really big corrective moves in government bond prices. Currently, investors do not seem to expect any volatility bursts in the Treasuries market, and the realization of such a scenario could come as a surprise to bond holders.

How Bonds Have Challenged their Flattening Trend?

The difference between 10-year and two-year Treasury yields currently stands at 0.83%, having formed a mid-September peak of 0.97%, just before the latest Fed and BoJ announcements. This flattening swing of the yield curve occurred after reversing the nine-year low of 0.76% it had reached around the end of August. This market action allowed the 10-2 year segment of the yield curve to break out from the flattening trendline it had been stuck in for the last 14 months. It also signified a potential reversal of this trend.

10-2 Year US Yield Curve

Source: stockcharts.com

The big question, of course is, if this bear move could extend itself further, or if it's just a respite from the big bull market that has been going on for years. According to a series of congruent macroeconomic, political, and technical factors, more bear steepening correction in US bonds becomes extremely possible in the short term.

Which Political Factors Could Weigh on US Bonds?

US Treasury bonds behave as though they have completely dismissed the possibility of a Trump win in the upcoming elections. As remote as that possibility might seem, there is too much information out there to ignore. Apart from the neck-to-neck battle the recent polls depict, a fact that can easily be dismissed since polls are notoriously unreliable, bookies assign a lower but non-negligible probability to a Trump presidency. This implied probability of a Trump victory should normally make bond holders extremely nervous in the face of a potential uncontrolled supply of government paper, especially given Donald's general preference for over-leveraging in the private and public sector. Pushing the public sector into more debt could cause an excessive and uncontrolled supply of government paper, which would ultimately bring enormous pressure on treasury prices, and skyrocket their yields. As the presidential election nears, the market will have no other choice but to consider this political scenario especially since the final days of the run will bring intense polarization. The only way it can put some weight on this probability is by adjusting the long-term bonds yields upwards, since the longest durations will be the ones that will most likely be affected by such an imprudent fiscal policy.

Which Macroeconomic Factors Affect US Bonds?

On the macroeconomic arena, even though the US economy currently seems to be languishing in a prolonged but "low altitude" business cycle, there are signals that China is "silently" picking up the slack. The Baltic Dry Index, a global gauge of the shipping cost of core raw materials, is boasting new highs for the year reaching the 941 level, thereby extending its latest six-month uptrend.

BDI

Source: stockcharts.com

This market behavior could reflect increased demand from China, especially for iron ore and other raw materials, which are being transported from third-party economies to feed its manufacturing needs. Copper, aluminum and zinc - with China responsible for almost half of their global consumption - are collectively exhibiting a resilient price behavior as well. Aluminum's price, surpassed $1,630/Tonne after hitting its six-year low of $1,446/Tonne late last year, negating its previous bear market.

Aluminum

Source: tradingeconomics.com

Zinc is approaching the highest levels of its eight-year fluctuation band, after a dynamic rebound from its last year's trough.

Zinc

Source: tradingeconomics.com

Copper is heading towards its upper trading levels for this year, having formed a sizable triangle consolidation formation. In case this formation breaks out to the upside, Copper will have signaled the initiation of a new and long-lasting bull market.

Copper

Source: tradingview.com

If the US fixed income market starts to take notice of these indications, reflective of a potential Chinese rebound, then US long-term yields could adjust fiercely upwards. After all, these long-term yields are much more anchored to global macroeconomic developments than short-term yields - which reflect Fed policy actions - are. Such a positive adjustment of the long-term yields, coupled with the gravitation of short-term yields closer to today levels, could easily extend the bear steeping movement of the yield curve, which has already begun.

If the Chinese rebound materializes, it will most likely be fueled by domestic forces, rather than by international trade, as China's major trading partners - USA, UK, Eurozone, Japan - are struggling with their own lackluster growth economies. This means that China's historic surpluses with the world will be undermined by having imports rising faster than exports, due to this domestic wealth effect. The shrinkage of surpluses could accelerate the recent trend of dumping US assets, which has brought the Chinese holdings of US Treasuries to less than 6.3% of the total public debt, from 7% back in June 2015. Less and less surplus money available for Treasury securities, effectively means less and less buying support for bond prices, which in turn means more and more yield spikes, as bond yields are inversely related to bond prices. This support mostly focuses on medium and long-term Treasury securities, so the potential gap in demand will focus on the long-end of the curve. This could intensify the steepening of the curve with long-term rates moving higher and faster than short-term ones.

China holdings of US debt

Source: Department of the Treasury/Federal Reserve Board

What Occupies Investors Minds?

While a lot of important factors are pointing towards a fierce bond market correction, investors do not expect a hike in volatility, which would accommodate such a development. In fact, the CBOE/CBOT 10-year U.S. Treasury Note Volatility Index, a gauge of expected volatility in 10-year Treasury prices over the next 30 days, has plunged to lower levels than it had during last August, before the first upward reversal of yields occurred. This reflects increased complacency among bond investors, indicating their conviction that there is no force capable of threatening the resilience of the bond market. The main reason for this complacency is because the recessionary economic discourse has been dominating investor perception, thus prohibiting them from considering other global factors. Additionally, the realized volatility of T-Note future prices is also plummeting to new lows and this affects investors' thinking about the future.

CBOE/CBOT 10-year U.S. Treasury Note Volatility Index

Source: CBOE

There are of course some risk factors which could prohibit this bear steepening scenario from unfolding, such as the escalation of the Deutsche Bank (NYSE:DB) crisis into a real challenge for German politicians, if markets decide to immediately test their no bail-out mantra. In such a case a global financial shock could easily inflate the US bond market bubble to new historical high prices (low yields), as risky assets around the world would be melting down. Another shock could be an abrupt devaluation of yuan, as China is increasingly faced with a more challenging international trade environment. This again could trigger risk-off trades around the world and could re-ignite the bull market in bonds. Apart from these kinds of exogenous shocks to the global economy, the bear steepening potential of US bonds gains credibility and should be carefully assessed by investors.

Locating the limits of such a counter-trend move in US Treasuries is of utmost importance for investors who would wish to re-invest in long-term bonds, increase the duration of their fixed income portfolios, or place bull-flattening trades, in advance of the next leg of the secular bull market in fixed income. A careful technical examination of the 10-2 year segment of the yield curve reveals that the area between 1% to 1.2%, could become the first and probably final target of this bear steepening scenario. This increase between short and long yields will, of course, be coupled with an increase at least in the long-term yields, and so bond holders could expect to witness some capital losses along the way.

With all this in mind, it seems that investors have not given any weight to a bear steepening shift of the US yield curve, at a time when there is plenty of evidence that this shift has already begun. A market with an estimated value of 20 trillion dollars is too big a market to ignore the possibility of a reversal. Bond investors simply cannot afford to turn a blind eye to any danger, as remote as that may seem.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The views expressed in this article are solely those of the author, provided solely for informative purposes and in no case constitute investment advice.