Bond Investors Must Deal With Trading Volatility

Bond investors are preparing for at least another year of rocky trading, as the daily double-digit movements in Treasury yields are jarring their confidence, abandoning hopes that the market is likely to return to normal at least by the year 2023.

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It's for this reason that they have to rethink their old playbooks devised during calmer and more predictable periods, and instead, seek investment strategies that are flexible and nimble in order to ride the most turbulent market now since 2008.

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As bonds fell this week after a surprise cut to global oil production, traders were reminded of the contrasting forces that are battering the market, but they bounced back after weak economic data later that evening. In spite of a softer reading on US job openings on Tuesday, the two-year yield continued to fall sharply below 4% as a result of the softer reading.

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A trader in this environment needs to be very agile and be willing to act opportunistically when yields swing into extremes and buy or sell at an opportune time. MUFG's head of macro strategy George Goncalves believes that the market will not regain a more sustained sense of calm until the Federal Reserve ends its tightening cycle and the economic picture becomes more clear.

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According to Goncalves, it was only wishful thinking to hope for less rate volatility this year. “There may not be a calm period before the middle of 2024 when rate volatility settles down,” he said.

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As investors in the $24 trillion US Treasury market had a lot to digest in the first quarter of the year, the first quarter felt like a full year of drama for them as there was so much to digest in such a short timeframe.

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After stronger-than-expected jobs and inflation readings fueled speculation on higher rates in February, recession fears in the first weeks of 2023 moderated to hopes of a soft landing. From its mid-January low, the two-year yield spiked to as high as 5.08% by the beginning of March.

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After Fed Chair Jerome Powell indicated a willingness to increase monetary tightening, Treasury rates exploded, but Silicon Valley Bank failed to ignite a brutal flight to bonds that echoed the global financial crisis's flight to haven assets. 3.55% was the lowest yield in two years after a 60-point plunge.

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Vineer Bhansali, the founder of LongTail Alpha LLC, a firm that invests in short-maturity bonds, told me that he has never seen anything like this happening with rates in short-maturity bonds in 35 years. He says such sharp swings are definitely a factor that influences the way he invests these days.

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As a former head of analytics at Pacific Investment Management Co. and head of portfolio management for Pacific Investment Management Co., Bhansali said he is unwilling to take much duration risk because he has no idea if we fall into an abyss and rates rally or if everything stabilizes. In general, I am primarily interested in trading the yield curve, in which I wager that it will steepen.

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It is of little surprise that the ICE BofA MOVE Index, which is a closely watched proxy for expected Treasury swings, has climbed to its highest level since 2008 - up more than double since the end of January, and this is despite so much uncertainty.

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Nevertheless, even this advance is understated when considering the extent of price fluctuations that have been occurring in recent months. In other words, the mid-March swing in two-year yields was the biggest since 1982, when Paul Volcker cut rates during a recession.

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As the market's outlook for rate cuts and hikes continues to change, Steve Bartolini, portfolio manager at T. Rowe Price, expects the two-year yield to remain more volatile than the rest of the curve.

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A surprise oil production cut by OPEC+ followed by a weak US manufacturing survey on Monday, causing the two-year yield to swing 17 basis points. The two-year yield jumped 20 basis points because of the softer labor-market report on Tuesday. As a result of the banking crisis, traders are trying to determine how much tightening in financial conditions could replace Fed rate hikes in the future.

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Following a sharp lean in that direction before the jobs-opening data at the beginning of this week, swap traders are now pricing in a one-in-two chance of a quarter-point rate hike in May. According to the latest “dot plot” of quarterly economic projections, the Fed is expected to cut its funds rate to about 4.30% by year's end. That's well below the median forecast of 5.1% by US officials.

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One of the investors supporting that view is Darren Davy, who was formerly affiliated with Soros Fund Management but is now affiliated with Lee Cooperman's Omega Family Office.

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The next 12 to 18 months will be an interesting period in global fixed income, according to Davy, who has worked in markets for 36 years. It is important to be very, very careful in such a volatile environment. It appears that yield curves are continuing to normalize and that duration is being priced at a premium.

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