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PIMCO: What's Happening to Bonds and Why?


History will regard the ongoing phase of dislocations as a transitional period of adjustment triggered by changing expectations about policy, the economy, and asset preferences.

Deploying a highly unconventional and experimental set of policy tools, the Fed resorted to repressed interest rates as their main transmission channel to meet their economic objectives, including higher employment. Specifically, in an attempt to use the portfolio channel to trigger a beneficial combination of the wealth effect and animal spirits, central bankers supplemented their traditional policy lever (namely, a federal funds rate floored near zero) with two more unconventional policy tools: aggressive policy statements (or "forward guidance") and large-scale market purchases of US Treasuries and mortgage-backed securities ("quantitative easing" or QE). As a result, and despite a multi-decade journey during which the yield on the 10-year bond declined from 16% at the end of September 1981 to below 2% at the end of April 2013, investors in fixed income were comforted by the notion that they enjoyed a "Fed put" at overvalued levels – which encouraged the justification of artificially high prices.

All of this changed markedly starting in April 2013. Since then, the Barclays US Aggregate has delivered a negative return of 4.5% (May through 6 September 2013) and bond funds have experienced sharp outflows.

The impact of higher interest rates overwhelmed the diversifying characteristics of virtually all other fixed income securities.

In many prior episodes of rising US Treasury yields (and especially those associated with materially improving economic fundamentals), credit-sensitive sectors of fixed income were supported by the tightening of credit risk spreads. In the most recent sell-off, however, even spread sectors came under pressure. Displaying higher correlation with Treasuries, credit spreads widened, thus selling off more than Treasury securities (see Figure 3, which includes market proxies for US Treasuries, investment grade corporates, emerging markets sovereigns, municipals and non-agency mortgages).

Policy, fundamentals, flows and technicals

US Treasuries have historically come under pressure due to two developments that are normally related; indeed, they have often occurred simultaneously: a recovery in nominal growth and a consequent tightening of monetary policy. And, over the last few weeks, there have been growing expectations of both.

Several data releases point to a US economy that continues to heal, albeit at a gradual pace -- thus lifting hopes that the US will finally be able to break out of the "New Normal" real growth rate of around 2%. Ongoing innovation, particularly in energy and technology, has amplified these hopes.

At the same time, starting on May 22, 2013, Fed officials began sending signals of their intention to taper their experimental support for markets and the economy. While the signals referred only to one (QE) of the three measures in place, and while the intention is to lessen the expansionary impulse rather than pivot to a contractionary one, markets have behaved as if all three were now in doubt. Simply put, the Fed is now seen as less able and/or less willing to continue with its current degree of policy accommodation.

The ensuing reaction of markets has been quite extreme. The sharp move in interest rates has been accompanied by an increase in volatility, pockets of liquidity dislocations, and unstable and changing correlations. In addition, short-end rates have been pressured higher even though this is the part of the yield curve that the Fed influences most by its current rate stance and its forward guidance.

Yet our analyses suggest that all of this reflects much more than market perceptions of an improving economy and a change in policy. Specifically, these movements have also been driven by notable shifts in financial asset preferences and related flows, along with some rather nasty market technicals.

Consider the following factors as partial illustrations:
  • After a first quarter of record inflows, approximately $106 billion has exited global fixed income mutual funds in 2013, with US retail funds particularly hard hit.
  • Risk parity investors have delevered quite forcefully due to an increase in rates and volatility, spiking correlations and aggressive drawdown control rules. Based on data from publicly traded mutual funds, we estimate that managers of risk parity portfolios sold over $60 billion of 10-Year equivalent in TIPS (Treasury Inflation-Protected Securities), nominal Treasuries and other interest-rate-sensitive securities.
  • Hedge funds have cut back on carry trades, particularly front-end exposures, despite the Fed's guidance that it will maintain near-zero interest rates for an extended period of time.
  • REITs (real estate investment trusts) and other mortgage-related investors have been sellers of interest-rate-sensitive securities as yields rose and mortgages extended in duration (consistent with the decline in refinancing at higher rates).
  • CFTC (Commodity Futures Trading Commission) data show that the collective net short position held in 5-year Treasury futures is now the largest in the last 3 years and among the largest in the last 5 years.
  • TIC (Treasury International Capital) data point to a decline in foreign purchases of U.S. Treasuries.
  • Broker-dealers have little appetite for inventory, thereby reducing the ability of markets to facilitate normal risk transfer (Figure 4).

Add to all this the selling by central banks (reserve managers) in emerging economies and a slow shift to lower duration benchmarks, and the result resembles for now a "technically damaged" asset class. In addition, with the recent decline in investor concerns about Syria, Europe, and China, the attraction of Treasuries as a flight to quality has receded in the most recent weeks.
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