Is The Bond Market On The Verge Of A Big Sell-Off?

by: Daryl Montgomery


Bond yields on the long end of the curve bottomed in July in a number of countries.

Negative yields at the long end of the curve have proven to be unstable.

Many fund managers think the markets are vulnerable to a "bond shock".

For the moment, it looks like global bond yields have bottomed this summer. The market was in an unstable state from a number of perspectives. Theoretically impossible negatives yields existed in government bonds in a number of countries. A JPMorgan survey indicated that the long position on sovereign debt was an unusually crowded trade, with the holdings of large portfolios two standard deviations (around the 98 percentile) above the medium-term average. The yield on the U.S. 10-year Treasury was trading richer relative to fair value than any time in the last four years. Something had to give, and it did.

When markets (or any other type of system) veer too far away from their average values, there is a desire to return back to the norm. In statistics, this is called regression toward the mean. When this behavior is at extreme levels, the market is in a bubble. It would be difficult to argue that the bond market, which has reached price levels that shouldn't exist according to classical economics, isn't at extreme levels. Most participants do indeed realize that there is a global bubble concentrated in Europe and Japan. The only question is - When does it burst? The bond bubble in Japan may have been around since the late 1990s, although negative yields are a more recent phenomenon. So, obviously bond bubbles can last for decades, and this is the case because they are artificially created by central bank policies.

Some sort of bottom on long-term yields was put in during July. It happened earlier in Europe and a little later in Japan. Yields in Europe dropped sharply after the Leave faction won the Brexit vote in the UK on June 23rd. By July 5th, the 50-year government bond in Switzerland had turned negative. That seemed to have been the signal that things had gone too far. The yield on the 10-year bund in Germany bottomed on July 8th, as did the U.S. 10-year Treasury. The yield on the Swiss 10-year bottomed on July 11th. It took until July 26th before the 10-year JGB yield hit a bottom in Japan, however.

German 10-Year Bund Yields Year to Date

Japanese 10-Year JGB Yields Year to Date

After the bottom, the instability of negative yields was quickly witnessed in both Europe and Japan. A sharp countermove took place in both places that quickly moved yields on the 10-year governments to just under zero within a few days in Germany and Japan. Yields in Switzerland - the most negative in the world - also rallied, but remained well below zero. Then, in August, yields moved mostly sideways and were under zero in Germany and Japan. In the first half of September, yields jumped above zero in Germany and clung to the zero line in Japan. The yield curve in the U.S. steepened for nine days in a row, with selling being especially pronounced in the 30-year Treasury. Essentially, long bonds in a number of countries were trading in the same direction.

U.S. 30-Year Treasury Yields Year to Date

Large investors had apparently become concerned that the European Central Bank (ECB) and the bank of Japan wouldn't be willing to, or even able to, continue their unconventional monetary policies. Indeed, negative interest rates can't be continued in the long term. Otherwise, banks, pension funds and insurance companies would all probably go under and the financial system would cease to function.

According to a Bank of America Merrill Lynch survey of fund managers, 54% thought both bonds and stocks were overvalued. About a third in total thought Treasuries would be the biggest driver of stock prices over the next 6 months. Respondents saw an unambiguous vulnerability to a bond shock in negative-yielding bonds and emerging market equities. They expressed concern over a bond bubble.

There are numerous short bond ETFs/ETNs that investors can use if they think bond yields are going to rise. On the long end of U.S. Treasuries, these include: TBT, TMV, TBF, DTYS, SBND, TTT and TYBS. In the middle of the Treasury curve, investors can choose among: PST, TBX, TYO, TBX, TYNS and TBZ. For high-yield bonds, there is SJB.

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.