What’s up with bond yields?

The consensus scenario appears to be that yields stay pegged at zero forever and beyond. I just don’t buy it.

Let’s imagine why long term rates would rise (Part 1), and what would happen if they did, even if just a little (Part 2).

A thread. https://twitter.com/aitkenadvisors/status/1326452210214051840

Part 1-

There are a number of forces that would put upward pressure on yields:

(A) Stronger economic fundamentals and growth

(B) Higher inflation expectations

(C) A supply/demand imbalance in the Treasury market

Let’s explore each of these in turn...

(A) Stronger economic growth:

Progress on a viable vaccine increases the hopes for a return to a semblance of economic normalcy.

Because a vaccine is good for economic growth (or at least, growth expectations), vaccine news will tend to put upward pressure on rates.

(B) Higher inflation expectations:

Fiscal measures that put money directly into the hands of consumers (unlike QE) could raise velocity and spur inflation.

The increased focus on fiscal stimulus going forward, then, could also put upward pressure on rates.

(C) S/D imbalance in Treasury market:

@AitkenAdvisors calls this “Treasury market indigestion”. Excessive Treasury issuance with too few buyers would cause yields to rise.

One caveat here: Treasury market indigestion is Powell‘s biggest nightmare; he will avoid it at all costs.

Part 2-

Now what would happen if rates rose?

Well, for one, debt at all levels (govt, corporate, household) is so high that any meaningful rise in rates would probably crash the financial system.

But what about if rates rose just a little bit?

Even if long term rates rose ever so slightly (say, 50-100bps), it would likely deliver a serious blow to Classic 60/40 and Risk Parity Portfolios (see pinned tweet).

This reason for this has to do in part with convexity, as I’ll explain.

With lower yields as a starting point, bond price volatility is heightened and the whole system is made less stable.

So even a small rise in rates could lead to big losses for Classic 60/40 Portfolios and cause many levered Risk Parity funds to unwind violently.

For those thinking “But YCC!”. Yes, the Fed will engage in some form of YCC. However:

(A) It would likely start with 3-5Y part of the curve, not the long end.

(B) Banks borrow short, lend long. So to spur bank lending, they may let long rates run and cap them at a higher level.

Despite all this, the whole equity space is positioned for lower (real) rates, with the aggregate market cap of lower rate beneficiaries currently at all-time highs as a percentage of $SPX + $RTY (see linked thread below).

So, uh, I guess let’s hope for lower rates then? https://twitter.com/teddyvallee/status/1325787482097643520

HT @AitkenAdvisors @hkuppy @profplum99 @vol_christopher @TaviCosta @jam_croissant @pineconemacro @TeddyVallee @ValueStockGeek @GreekFire23

I’m still thinking through convexity and other aspects here. Would greatly appreciate any thoughts/comments/criticisms.