Bond Market Is Overplaying the Risk of a Deep Recession

(Bloomberg) — When banks started going belly-up, the reaction in bonds was emphatic. Two-year Treasury yields slid a percentage point over three days in March, the most since 1982.

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For traders accustomed to treating such signals as sacrosanct, the message was obvious. Gone were the days when inflation was their main menace. Rates showed stress in the financial system made a recession inevitable.

Or did they? Three weeks later, questions won’t stop swirling about what to make of fixed-income volatility that for all its ferociousness remains mostly absent in equities and credit.

Explaining the divide has become a Wall Street obsession — an urgent one, given the sway Treasuries hold in models designed to divine the future of inflation and Federal Reserve policy. One concern is whether things having nothing to do with the economy — bearish positioning among speculators, specifically — made the big drop in yields a recessionary false alarm.

“Each day that there isn’t a banking crisis is another day indicating that the current pricing doesn’t make sense, but it’s going to take a while,” said Bob Elliott, chief investment officer of Unlimited Funds, who worked for Bridgewater Associates for 13 years.

As usual in markets, the debate is far from settled, and the lurch in yields may end up being what it usually is: a grim signal for the future of the economy. While oases of calm at present, stocks themselves are a long way from sounding an all-clear. Their big declines last year, and the dominance of megacap technology shares atop the 2023 leader board, can be viewed as portents of trouble. Similar wrinkles exist in corporate credit.

Still, the gap in market reactions to March’s events continues to border on the historic. The stock market, usually an arena for shoot-first speculators whose grasp of big-picture meanings can be tenuous, absorbed Silicon Valley Bank’s downfall and the contagion fears that followed with relative ease. In credit, blue-chip and high-yield spreads never got wider than levels seen last fall.

Meanwhile, daily fluctuations in two-year Treasury yields erupted last month into the widest in 40 years. The ICE BofA MOVE Index, which tracks expected swings in Treasuries as measured by one-month options, climbed in mid-March to its highest since 2008, opening the biggest gap between stock and bond volatility in 15 years as well. Even after things calmed a bit, the gauge remains more than double its average over the past decade.

In normal times, so violent a repricing would be one of the strongest signals markets could send that a recession is at hand. Right now, the interpretation is less obvious, according to Bespoke Investment Group’s George Pearkes.

“The Treasury market isn’t trading every moment in pure fear mode, but that doesn’t mean that what’s currently in the price is some sort of prescient, ‘This is how to think about it’ signal,” said Pearkes, the firm’s global macro strategist. “Rates are way too low. We haven’t seen signs of a broader metastasizing into credit markets, into the broader banking sector, of the deposit flight story, other than a few regional banks.”

Phrased differently: “The bond market has gone berserk,” says Dominique Dwor-Frecaut, a senior market strategist at the research firm Macro Hive Ltd., who previously worked in the New York Fed’s markets group. “For once, I’m on the side of equity markets. I don’t see a recession coming.”

Any suggestion stock jocks had a better handle on the events of the last month will rankle the fixed-income set, long viewed as the smarter money among asset classes. But positioning data supports the view. Equity hedge funds spent nine weeks prior to the SVB blowup trimming bank shares and, on balance, long exposure among asset managers was near the lowest level in a decade after the drubbings of last year.

Meanwhile, the $24 trillion Treasury market’s setup in early March left bond traders vulnerable. Citigroup Inc. models and Commodity Futures Trading Commission data show that bets against two-year Treasuries had climbed to record levels ahead of the sudden collapse of Silicon Valley Bank, thrashing hedge funds and speculators as markets dramatically recalibrated Fed expectations.

Of course, less than a month out from the failure of three banks and the government-sponsored bailout of a fourth in Europe, it’s too early for optimism, even as Treasury Secretary Janet Yellen says the system is showing signs of stabilization. Harley Bassman, the former Merrill managing director who created the MOVE index in 1994, said it’s not unusual for the VIX — the equity volatility benchmark — and the MOVE to flash different signals, but history shows it doesn’t last.

“It’s just a matter of time until the VIX picks up,” said Bassman, who’s a managing partner at Simplify Asset Management Inc. “Over the past thirty years we’ve seen large correlation between the shape of the yield curve, credit spreads an implied volatility – and I mean all the volatility measures including the VIX and MOVE. The whole pack of the risk metrics are very correlated over the long term.”

Short-covering in bonds was made more painful by strained trading conditions. After deteriorating for months, already thin liquidity worsened in the bond market amid the chaos. The violence even prompted a rare trading halt in a key corner of the rates market as volatility surged, exacerbating the price swings.

“The market is extremely illiquid. What this reminds me of is the 2008-09 illiquidity in the bond markets. It’s kind of similar. You cannot afford to get stuck with a bad position,” said Vineer Bhansali, founder of LongTail Alpha LLC and the former head of analytics for portfolio management at Pacific Investment Management Co. “The Treasury market is a roach motel right now. You can get in but you can’t get out. So be very careful.”

That rush for the exits has left a gaping mark in the charts even as volatility subsides. Though a semblance of normal price action has returned in recent days, two-year Treasury yields are more than a full percentage point lower than where they entered March. Yields are still languishing near levels reached in the aftermath of SVB’s implosion, even as bond traders ease up on the most dramatic pricing for Fed rate cuts.

But after such a violent flush-out, the question becomes which managers are willing to step in and short the bond market again. In fact, investors have flocked to the opposite side of that trade: data from Citi show that speculators have largely covered their shorts on front-end bonds, while positioning has flipped into bullish territory on some parts of the curve.

The large dislocations between Treasuries with stocks and credit could take months to heal as macro managers “lick their wounds,” according to Unlimited’s Elliott. But as concern over the health of the banking industry continues to ebb, it’ll become more and more tempting to step in.

“The macro funds that were positioned for higher-for-longer are unlikely to start leveraging back up, regardless of what the pricing is. They just got burned by it,” Elliott said. “The folks that were previously short the two-year, it’s going to take a series of data points to get confident enough to start selling those positions again.”