Six years ago, this researcher uncovered why bonds sell off
Long-term bond yields are experiencing a surge due to the Federal Reserve gradually reducing its bond portfolio while the U.S. Treasury sells debt to cover government spending. This unexpected move surprised Wall Street and global investors, although a research paper from six years ago accurately predicted this situation. Authored by a University of Michigan doctoral candidate, the paper highlighted the crucial role of the correlation between bond and stock markets in determining the market's capacity to absorb new issuances.
Steve Hou, currently a quantitative researcher for Bloomberg, reflected on the initial scepticism surrounding this topic, noting that some central banks, including the Bank of Canada and the Cleveland Fed, paid attention. The paper envisioned a scenario where the stock-bond correlation would no longer be deeply negative, leading to a pronounced price elasticity for bonds—a concept deemed far-fetched then.
Hou's paper explained that when bond and stock markets move in opposite directions, bonds serve as an effective hedge for stocks, facilitating the absorption of new Treasury supply. Conversely, a positive correlation, where stocks and bonds move in the same direction, increases bond risk premiums due to increased Treasury supply.
As predicted, the Treasury's plans to borrow $1 trillion in the July-to-September quarter and $852 billion in the October-to-December quarter led to a spike in the yields of the 10-year and 30-year Treasuries. Bond yields, inversely related to prices, surged again after a stronger-than-expected payroll growth.
Hou emphasized that the inevitability of this shift was due to excessively low yields, driven by concerns about a potential recession. Recent economic data, however, have pushed recession fears further into the future. Despite structural reasons justifying higher bond yields, such as inflation and geopolitical tensions, discussions of 6% or 7% yields are deemed excessive.
Hou, formerly a quantitative researcher at AQR Capital Management, expressed surprise at the significant decline in bond values. While acknowledging the potential for a reversal of the 40-year trend of disinflation and declining 10-year yields, he remained cautious about whether that point had been reached.
In the broader perspective, institutions functioning as arbitrageurs, like trading desks or hedge funds, face inherent exposure to stock market risks. Significant players like Pimco and JPMorgan Chase, with limited balance sheet capacity, contribute to an international linkage, evident in rising sovereign bond yields in Europe despite differing fundamentals from the U.S. market. The common thread is the assumption of similar sovereign risk across different currencies.