Bad years for US Treasuries don’t mean bad years for markets

LONDON (Reuters) – It’s a rare year when total returns on US Treasuries are negative, but when they are, the ripple effect on global markets is potent.

Stocks, credit, high yield and emerging markets, in particular, suffer as investors bail out of the world’s safest and most liquid asset, pushing up the cost of money, squeezing liquidity and tightening financial conditions.

That’s the running assumption, and it’s setting the narrative for financial markets right now as the US bond selloff gathers pace and Treasuries close in on what will be only their fifth year of negative returns since the early 1970s.

Trouble is, that’s not how it necessarily pans out. The previous four years of negative Treasuries returns – 1994, 1999, 2009 and 2013 – show a widely mixed response across global markets.

The following table shows how a clutch of major financial market indices and assets performed in these previous four years and how they are faring so far this year.

In each of these years the 10-year US Treasury yield rose at least 80 basis points, with the 204 bps spike in 1994 still the largest annual rise on record. So far this year, the yield is up 84 bps and many observers believe it is heading higher.

Much depends on that indefinable notion of whether bond prices are falling for “good” reasons – a booming economy, meaning an orderly selloff – or “bad” reasons – fears that the Fed is behind the curve and will be forced to jack up rates aggressively, resulting in a disorderly selloff.

This year has seen a bit of both. US growth has been stellar and the Fed has stuck to its steady path of raising rates. But fears that the Fed will have to do much more, thereby choking growth and precipitating the long-awaited downturn, have intensified in recent weeks.

The 10-year yield fluctuated in a 2.75-3.10 pct range for most of the year, almost always below 3.00 pct. But in mid-September it broke convincingly above 3.00 pct and this week surged to a seven-year high of 3.26 pct.

The fear is what has been a relatively orderly selloff in the bond market up to now could turn into something more resembling a rout. The 10.5 basis points rise on Wednesday, October 3 was the biggest one-day rise since the day after the US presidential election nearly two years ago.

Analysts at Goldman Sachs draw a distinction between the “nowhere to hide” bond bear markets during the two World Wars and the periods of stagflation in the 1970s and 1980s, and the bouts of bond market weakness since the 1990s, excluding 1994.

The “nowhere to hide” bear markets saw sharp declines across many asset classes as markets repriced growth and inflation risks. But most downturns since the 1990s have been against a backdrop of anchored inflation and inflation expectations, meaning they are shorter and more shallow in both nominal and real terms.

“Bond bear markets have become less of a concern for multi-asset investors,” they wrote in a note last week. “With anchored inflation and gradual monetary tightening the (equity) bear might hibernate for longer.”

But complacency is dangerous. Bond bears cite several reasons why yields should carry on rising: economic fundamentals still look strong, the Fed shows no sign of slowing down, it is increasing the pace of its balance sheet reduction, and the supply of new bonds is soaring as the budget deficit widens.

Others argue that US growth has topped out, the shape of the yield curve is a warning that the slowdown could turn into recession by 2020, so the Fed won’t raise rates as much as it is indicating or the market expects.

Either way, markets are beginning to feel the heat from the latest lurch lower in US bonds.

Emerging equities slumped 4.5 pct last week, the biggest fall since February and second biggest in almost three years; last week was the worst for global high yield since late June; world stocks fell 1.8 pct; and if the S&P 500 closes in the red this week it will be the first time since mid-2016 it has fallen three weeks in a row.

How they fare in the final stretch of the year, and the complexion that puts on 2018 as a whole, will depend a lot on how Treasuries behave. The alarm bells from an increasingly disorderly fall will surely ring far and wide.