INVESTORS are starting to question the epic bond rally that's driven global yields to new lows and fuelled the US Treasury market's best performance since the era of quantitative easing.
The warning signs go beyond this week's failed German 30-year bond auction, which showed that demand may be faltering for negative yields across Europe, even amid growing evidence of ebbing economic growth.
In the US, the momentum buyers who latched on to falling yields are seeing signs rates could be bottoming out, with volatility rising and market depth deteriorating. Cliff Asness, co-founder of quantitative investing giant AQR Capital Management, summed up valuation concerns in a blog post this month titled "Bonds are Frickin' Expensive". While Treasuries aren't "an automatic huge short", the levels are at least worth discussing with yields at such historical extremes, he wrote.
"It's sort of been the momentum traders' dream trade," said Kathryn Kaminski, chief research strategist and portfolio manager at AlphaSimplex Group. "Our conviction for bonds is still very strong, but there has been increased volatility - so in risky terms, risk trade-off has gotten worse. And, with more risk, you become a little bit more sceptical." Amid US-China trade tension and worries about the global economy, yields plunged last week. Rates on 10-year Treasuries breached 1.5 per cent for the first time since 2016, and 30-year yields fell to record lows below 2 per cent . The market's bellwether US recession indicator - the 2- to 10-year yield gap - inverted for the first time since 2007, sending stocks tumbling.
For traders riding the bond rally, it's been a stellar year. So good, in fact, that it's raising a warning flag for strategists at Societe Generale.
A SocGen index tracking the trend-following strategy in government-debt futures has climbed to a record, with algorithms positioned long across the curve.
"A strong performance by trend-following is usually followed by a reversal," the strategists wrote in a note.
Even for bond bulls, the market swings seen in the past few weeks are a reason to question the merit of staying long. Volatility on 3-month options for US 10-year interest-rate swaps rose this month to the highest since January 2017.
Powell ahead
And there may be more turbulence on Friday when Federal Reserve Chairman Jerome Powell speaks at the central bank's annual gathering in Wyoming. On Wednesday, minutes from the Fed's July gathering showed officials viewed last month's rate cut as insurance against headwinds from trade and low inflation.
With those forces persisting, traders expect another easing in September. But they got a reminder on Thursday of the risk to that stance, and to the case for lower yields, as three Fed policy makers lined up against additional rate cuts.
Ms Kaminski, who with her team used statistical measures to guide their managed-futures strategy to go all-in on Treasuries early in the year, notes that volatility has been even more pronounced in long-term debt. Falling trading volume and liquidity have induced them to "marginally" cut bullish Treasury wagers, she said.
Much of this summer's bond frenzy took place amid thin trading, which indicates there could be less investor conviction than such a sharp tumble in yields would otherwise suggest.
A JPMorgan Chase & Co measure of market depth - the ability to trade Treasuries without substantially moving prices - at one point this month fell as much as about 60 per cent below its 12-month average. It's also been low even by the standards of a typical August.
"High-frequency and algorithmic traders have been playing an increasing role in the market and their participation tends to drop off pretty significantly when volatility gets beyond certain parameters," said Alex Roever, head of US rates strategy at JPMorgan. "We've seen that in August. Given the low depth, you can't quite take the yield levels at face value." Mr Roever and his group predict 10-year yields will rise, yet may fail to reach the bank's year-end forecast of 1.95 per cent , compared with about 1.6 per cent now.
The world's biggest bond market has been hard to pass up this year. Treasuries have gained 8.1 per cent, leaving them on track for their best annual performance since 2011, according to the Bloomberg Barclays US Treasury Index. That means 2019, even with the tightest job market in 50 years, is delivering the biggest returns since the days of full-fledged Fed quantitative easing.
Insurance policy
Peter Sleep, senior money manager at Seven Investment Management LLP, also sees Treasuries as pricey. Yet as global risks abound, he's mostly hanging on.
"In our funds, we are slightly underweight duration due to the lack of value," he said. "But we continue to hold them as they are our insurance policy from tail risks, or events which were once tail risk and are now very real, like Brexit." Yet some hedge funds are turning to gold as a refuge as the world's stockpile of negative-yielding debt grows bigger by the day.
The yellow metal is favoured by Ensemble Capital's Damien Loh, a former options trader at JPMorgan Chase & Co, as global bond valuations reach nosebleed territory. AMP Capital Investors Ltd's dynamic fund is also backing bullion, while Morphic Asset Management Pty is betting on gold to outperform the dollar.
There's no denying the darkening economic backdrop. German output shrank in the second quarter, and figures on Thursday showed the first contraction in US factory activity since 2009.
But even with that fear factor, and the roughly US$16 trillion pool of global debt with sub-zero rates luring money to Treasuries, there are signs of investor fatigue.
"We think things have become a bit stretched here," said Chris Chapman, portfolio manager at Manulife Investment Management. "The market is pricing a lot of worst-case outcomes, and summertime illiquidity has exacerbated the moves. We've been trimming duration, mostly in the US." BLOOMBERG
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