When to buy Bonds
When to buy Bonds
It wasn't the case a year ago, is it now? Is it?
A catchy title, isn’t it? I am learning a thing or two to attract people’s attention. I have to admit that I saw this title in a recent research presentation, and I was both curious and somewhat astonished by the question's simplicity. There are so many things in there to discuss. I mean, where do you even start?
In my previous post, I analyzed the relative attractiveness of bonds versus pretty much all other traditional asset classes given current macro currents and the somewhat inevitable recession, which everyone now expects to hit us next year.
Somewhat expectedly, everyone’s shouting for fixed income to have a good run next year. I am cautious and amused, as the same people were telling you that rates, as our monetary leaders were guiding us, wouldn’t rise for at least 2 years back in 2021. Oh well. How do you like them apples?
Similarly, it is now pretty consensus that inflation will settle above target for some years to come. Disregard the nutters, I would say.
Let’s instead look at the Fred chart below. What does your intuition tell you? The shaded areas are recessions.
I will admit it wholeheartedly that I absolutely adore bonds and that I was long bonds for most of my career. It didn’t only have a place as a stand-alone asset in fixed-income portfolios. More importantly, government bonds were also a very good addition to pretty much any asset allocation strategy out there. A wonderful diversifier. Why do you think risk parity did so well until, err, recently?
Which other asset would pay you a coupon (positive “carry”) to offer insurance against volatile market events? Which other asset would carry out many careers over the past decades for shorting their compadres like JGB’s and Bunds? Bonds ain’t no joke. Look at the total returns below.
Yes, the past is gone and dusted, but we can certainly ascertain a few thoughts about when it’s usually a good time to buy bonds and adapt them to the current environment.
The excellent people at BCA research have conducted a great analysis in this regard. So let’s dig in and see what they say.
So taking the most recent bond bull markets, you can see that excess returns a few months before the last rate hike are relatively unattractive versus holding cash. The attractive investment window opens up on average eight months before the last hike and the first cut.
Of course, there is no way of knowing when the last rate hike has been concluded. The interesting bit for me is the affirmation that there is still a lot of meat in the bond trade once the first cut has occurred. Hold your horses!
In terms of timeframes, the table below offers more clues as to how to play this directionally versus curve plays. For example, on average, 10-year treasury yields peak roughly a month before the last hike. Similarly, according to this table, the 5/30s curve throughs around 2 months before the last rate hike, with other yield curve differentials following a few months later.
A quick glance at the 5-30s chart below would indeed confirm a soft predictive pattern. It makes sense as 5s move ahead of the more anchored front-end rates. Beautiful isn’t it?
What does this mean in the current context?
Money market forward curves would imply the peak in rates for May 2023 at around 5%. That would mean a hike from the widely expected upper band of 4.5% next week to 5% in 3 meetings (Feb, Mar, May). That’s quite a step-down and then halt scenario.
I am not convinced that the elected leaders in the Eccles building have the same script in mind, not with how resilient the labour market still seems to be and how backwards-looking their reaction function has historically been.
In any case, the bond market has obviously settled into this scenario. What do you think? If you believe that next week’s rate hike will be the last in this cycle, by all means, load the boat with bonds.
If you are, like me, still on the fence as to how far this Fed is willing to ramp up rates, then waiting is probably a better strategy. I am, however, itching to put on a steepener at current levels given the carry and the timing optionality. In short, a better risk-reward in pre-empting the end of the rate cycle than playing it directionally.
My overall thinking, as implied by the above tables, is that even if I am wrong and we are closer to the end of this rate hiking cycle, there is still plenty of bond money on the table for PaperAlfa to be excited about.
If, however, the current pricing, once again, gets pushed out and possibly to a higher terminal rate due to stickier-than-predicted inflation and/or realised growth, I will be able to lock in higher rates in the months ahead. In any case, I will be following up on those dynamics in the months ahead as we inch inevitably closer to the end of this hiking cycle. Stay tuned.
Thanks for reading,
Paper Alfa
I detect a socratic approach here rather than didactic or, possibly, an existential view: bonds are in a state of becoming. As I fear commitment, I will "stand and wait" in T-bills. Excellent comment btw.
"They also serve who only stand and wait.” Milton
https://www.youtube.com/watch?v=ErvgV4P6Fzc
Thank you for sharing your knowledge! This is a fantastic lesson.