Bond Traders Weekly Outlook: Risk On to Risk Off Transition Feeding Emerging Market Contagion

Financial conditions tightened, “risk on” has begun the transition to “risk off,” with the system now vulnerable to an abrupt change in the liquidity backdrop. U.S. Treasuries closed out a turbulent a down week with a strong Friday rebound 2-yr notes reclaimed the bulk of this week’s loss as the long end continued its recent underperformance. Friday saw safe haven buying as there appears realization that China’s economy and its real estate sector in particular are of morose health. This week the 2s10s spread expanded by six basis points to -66 bps. Crude oil surrendered broke a 7-week winning streak to settle $2.54, or 3.1% lower for the week. The U.S. Dollar Index on Friday closed at 103.40 closing just above its 200-day moving average (103.23), gaining 0.5% for the week.

Hungry Bond Traders

There is a firm belief the Central Banks have been blindly raising rates because ‘they have to’ and the consequences will be dire, furthermore that the US Administration is bumbling along with damaging decisions one after the other.

Understandably, aware of past Fed behavior markets are conditioned for loose conditions. They expect Fed loosening measures to reverse any meaningful tightening, hence constant flipping between end of inflation and hawkish Fed speaks trades.

Weekly Recap

Another vicious week for bond markets with Treasuries lower for the fourth week in a row as yields continued to rise. Financial conditions tightened, “risk on” has begun the transition to “risk off,” with the system now vulnerable to an abrupt change in the liquidity backdrop. U.S. Treasuries closed out a turbulent a down week with a strong Friday rebound 2-yr notes reclaimed the bulk of this week’s loss as the long end continued its recent underperformance.

China cracks widening

China today has the largest banking system in the world, rapidly approaching $60 TN. It is meaningful that China’s “big four” bank CDS spiked higher this week.

  • Bank of China CDS surged 22 (biggest move since November) to 86 bps.
  • China Construction Bank jumped 21 (biggest since October) to 98 bps,
  • Industrial and Commercial Bank 21 (October) to 98 bps,
  • China Development Bank 17 to 90 bps.

Developer bond collapse continues at pace, “last man standing” Vanke CDS spiked 404 to 884 bps, while the company’s bond yields surged 336 bps to 12.04%.

The “AMCs” aka the “bad bank” asset management companies created back in 1999 to clean up a troubled banking system are holding water and bursting.

  • Huarong CDS spiked 161 this week to 652 bps – the biggest move since March.
  • China Orient surged 45 to a near record high 372 bps,
  • China Cinda rose 38 to 282 bps.

Key Catalysts that empowered latest Treasury sell off:

“Based on projected intermediate- to long-term borrowing needs, Treasury intends to gradually increase coupon auction sizes beginning with the August to October 2023 quarter. While these changes will make substantial progress towards aligning auction sizes with intermediate- to long-term borrowing needs, further gradual increases will likely be necessary in future quarters.”

August 11 – Bloomberg (Farah Elbahrawy and Greg Ritchie): “US Treasuries are on course for a record year of inflows as investors chasing some of the highest yields in months pile into cash and bonds, according to Bank of America… Cash funds attracted $20.5 billion and investors poured $6.9 billion into bonds in the week through August 9… Meanwhile, US stocks had their first outflow in three weeks at $1.6 billion. Flows into Treasuries have reached $127 billion this year, set for an annualized record of $206 billion, BofA said.”

Yield Watch

Friday/Week

  • 2-yr: -5 bps to 4.91% (+2 bps for the week)
  • 3-yr: -4 bps to 4.64% (+8 bps for the week)
  • 5-yr: -6 bps to 4.38% (+7 bps for the week)
  • 10-yr: -6 bps to 4.25% (+8 bps for the week)
  • 30-yr: -3 bps to 4.38% (+11 bps for the week)

Key Rates and Spreads

Rates

  • 10-year Treasury bonds 4.30%, up +.13% w/w (1-yr range: 2.60-4.30) (12 year high 8/18/23 w/e)
  • Credit spread 1.87%, unchanged w/w (1-yr range: 1.76-2.42)
  • BAA corporate bond index 6.17%, up +.13% w/w (1-yr range: 5.00-6.59) (10 year+ high)
  • 30-Year conventional mortgage rate 7.37%, up +0.23% w/w (5.05-7.37) (tied for 20+ year high 8/18/23 w/e)

Yield Curve

  • 10-year minus 2-year: -0.69%, up +.04% w/w (1-yr range: -1.06 – 1.59) (new 40 year low)
  • 10-year minus 3-month: -1.19%, up +0.07% w/w (1-yr range: -1.69 – 2.04) (new low)
  • 2-year minus Fed funds: -0.39%, up +0.04% w/w
10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity (T10Y2Y)

Money Market Flows

  • Investment-grade bond funds posted outflows of $575 million, and junk bond funds reported negative flows of $1.090 billion (from Lipper).
  • Total money market fund assets surged $39.7bn to a record $5.570 TN, with a 23-week gain of $676bn (31% annualized). Total money funds were up $1.008 TN, or 22.1%, y-o-y.
  • Total Commercial Paper slipped $5.3bn to $1.166 TN. CP was down $24bn, or 2.0%, over the past year

COT on bonds Aug 11: Leveraged funds-maintained a near record short across the US yield curve in the wk to Aug 8 when the curve steepened with 2’s down 15 bps and 30’s up 11 bps. Especially the bearish long-end exposure remains extreme with the combined DV01 (value of one bp yield change) on T-Bond and T-Bond Ultra above 140m dollars. @Ole_S_Hansen

Bond auctions this week:

Bills

Bond auctions week ahead:

Next week will bring some new supply.

  • Monday: 13- and 26-week bills,
  • Tuesday: 52-week bills; 42-day CMB,
  • Wednesday: 17-week bills;
  • Thursday: 4- and 8-week bills,

10 Year Note Technical Analysis via KnovaWave

Highlights – Federal Reserve

  • Federal Reserve Credit declined $17.7bn last week to $8.154 TN.
  • Fed Credit was down $747bn from the June 22nd, 2022, peak.
  • Over the past 205 weeks, Fed Credit expanded $4.427 TN, or 119%.
  • Fed Credit inflated $5.343 TN, or 190%, over the past 562 weeks.
  • Fed holdings for foreign owners of Treasury, Agency Debt declined $4.8bn last week to $3.449 TN.
  • “Custody holdings” were up $68bn, or 2.0%, y-o-y.

Powell at the FOMC: “The federal-funds rate is at a restrictive level now. So, if we see inflation coming down credibly, sustainably, then we don’t need to be at a restrictive level anymore. We can move back to a neutral level and then below a neutral level at a certain point… And you’d start cutting before you got to 2% inflation too. Because we don’t see ourselves getting to 2% inflation until—you know, all the way back to 2 until 2025 or so.”

Central Bank Watch – Week Ahead Focus on PBOC, FOMC and RBA Minutes

Highlights – Mortgage Market

  • Freddie Mac 30-year fixed mortgage rates surged 27 bps to 7.22% (up 209bps y-o-y) – the high back to 2001.
  • Fifteen-year rates jumped 26 bps to 6.65% (up 210bps).
  • Five-year hybrid ARM rates declined seven bps to 6.71% (up 232bps).
  • Bankrate’s survey of jumbo mortgage borrowing costs had 30-year fixed rates up seven bps to 7.58% (up 191bps).
Mortgage News Daily

Global Bond Watch

Higher for longer is a serious threat.

Global Yields Spiking Higher

Surging market yields are a serious issue for a banking system loaded with long duration securities portfolios. This may well be a push over the cliff for troubled commercial real estate (CRE). Leveraged lending and leveraged finance gets more costly. Simply there are trillions of floating rate loans among individuals, speculators, businesses, and nations.

Contagion Emerging Market (EM) bond yields reversed sharply higher.

Emerging Market (EM) CDS jumped 19 to 222 bps, the largest weekly gain since the banking crisis week of March 17th.

(August 18,2023)

  • Vietnam CDS rose 13 to 128 bps,
  • Philippines 12 to 114 bps, Indonesia 12 to 93 bps.
  • Panama CDS surged 21 (largest gain since September 2022) to 118 bps,
  • Colombia 21 (largest since March) to 229 bps,
  • Brazil 18 (March) to 192 bps, Peru 16 (March) to 87 bps,
  • Mexico 10 (March) to 115 bps.

Dollar denominated EM debt surged higher

  • Peru jumped 27 bps to a five-month high 5.67%;
  • Philippines 31 bps to a five-month high 5.26%;
  • Indonesia 29 bps to a nine-month high 5.27%;
  • Brazil 23 bps to a near 10-month high 6.59%;
  • Mexico 19 bps to a nine-month high 5.95%;
  • Chile 22 to a nine-month high 5.42%.

Local currency yields

  • 132 bps in Brazil to a two-month high 11.24%.
  • Mexico yields jumped 27 bps to 9.33%,
  • Colombia surged 46 bps to 10.89%.

Crude oil bounced off its 50-day moving average (71.29), rising toward its June high (75.06). With the pullback in yields the U.S. Dollar Index fell 0.9% to 102.28 through its 50-day moving average (102.92), resulting in a 0.6% loss for the week.

Major Benchmark 10-year Bond markets

Bond Market Performance 2023

Major 10-year Bonds/Notes

Highlights – European Bonds

  • Greek 10-year yields added three bps to 3.92% (down 65bps y-t-d).
  • Italian yields rose eight bps to 4.33% (down 37bps).
  • Spain’s 10-year yields gained four bps to 3.68% (up 16bps).
  • German bund yields were unchanged at 2.62% (up 18bps).
  • French yields added a basis point to 3.16% (up 18bps).
  • The French to German 10-year bond spread widened one to 54 bps.
  • U.K. 10-year gilt yields jumped 15 bps to 4.68% (up 100bps).

Gilts Sold Reminds of Risk.

(We keep this as a reminder so events like Fitch’s downgrade of the US are not a Suprise)

Post ADP, Pre-June CPI/PPI Dropped:

  • UK 10-year yields were up 16 bps Thursday to 5.54%, with two-year yields surging as much as 18 bps to a 15-year high 5.54%. Reminiscent of last fall, UK yields were pulling global yields higher – even before the jolt from strong U.S. data.
  • Italian 10-year yields surged 21 bps Thursday (4.37%),
  • Greek yields jumped 18 bps (3.97%).
  • Ten-year yields rose 17 bps in Spain (3.70%) and Portugal (3.36%).
  • Canadian 10-year yields surged 30 bps this week to an eight-month high of 3.57%.
  • Australian 10-year yields jumped 23 bps this week to 4.26% – the high since January 2014.
  • New Zealand yields rose 22 bps to 4.85% – the high since July 2011.

The UK’s 10-year bond yields are the highest in the G7, as markets continue to worry about the extent of interest rate hikes that will be needed to bring inflation back under control.

Highlights – Asian Bonds

  • Japanese 10-year “JGB” yields rose five bps to 0.64% (up 21bps y-t-d).

The Bank of Japan and its new Governor felt compelled to do, so, it tinkered with YCC (yield curve control), cleverly achieving some flexibility without unleashing a panic. Ueda adjusting a policy after signaling no move would be forthcoming left the markets feeling ‘betrayed’. There was a leak the day before the meeting. Ueda stated the YCC tweak “didn’t represent a step toward normalization” and the “BOJ still sees a long way to achieving price goal.” Ah, huh … the market sighed collectively.

July 28 – Financial Times (Kana Inagaki, Leo Lewis and Hudson Lockett): “The Bank of Japan has eased controls on its government bond market, altering a cornerstone of its ultra-loose monetary policy and prompting a surge in the country’s benchmark bond yields to the highest level in nine years. In an unexpected move, the BoJ said it would offer to buy 10-year Japanese government bonds at 1% in fixed-rate operations, in effect widening the trading band on long-term yields. The central bank added that it was technically maintaining its previous 0.5% cap on 10-year bond yields, but this level would be a ‘reference’ rather than a ‘rigid limit’. The move triggered confusion about whether the central bank would make further moves to unwind its easing policy, which has come under pressure this year from inflation that has hit four-decade highs. But the BoJ held its overnight rate at minus 0.1%, saying more time was needed to sustainably achieve its 2% inflation target.”

Key US Bond Auction Highlights

Inflation Matters

Inflation with Henry Kaufman

Kaufman is the legendary chief economist and head of bond market research at Salomon Brothers is someone who knows Inflation.  Henry Kaufman in an interview with Bloomberg’s Erik Schatzker Jan 14, 2022:

 “I don’t think this Federal Reserve and this leadership has the stamina to act decisively. They’ll act incrementally. In order to turn the market around to a more non-inflationary attitude, you have to shock the market. You can’t raise interest rates bit-by-bit.”

“The longer the Fed takes to tackle a high rate of inflation, the more inflationary psychology is embedded in the private sector — and the more it will have to shock the system.”

“‘It’s dangerous to use the word transitory,’ Kaufman said. ‘The minute you say transitory, it means you’re willing to tolerate some inflation.’ That, he said, undermines the Fed’s role of maintaining economic and financial stability to achieve ‘reasonable non-inflationary growth.’”

Inflation, Disinflation

US Producer Prices Higher in July, Rising Energy Prices Concern Markets
Consumer Inflation in July +0.2%, Shelter Accounted for Over 90% of Rise
Core PCE inflation Falls to +4.1% from 4.6% in June
FAO World Food Price Index Fell in March for Twelfth Consecutive Month

The rubber is meeting the road as the trifecta of rising interest rates, the Russian invasion of Ukraine and surging costs continues to weigh, this has been no surprise to us here and shouldn’t have been to the market and PTB. You can only play with fire for so long before you get scorched!

With all the redirection of blame at the Fed about inflation one has to understand it is a global phenomenon outside the Fed’s Control. With the war drums louder than ever the supply chain issues are out of control. The Federal Reserve is not in control of global energy and commodities prices.

Everything points to powerful inflationary dynamics and a Federal Reserve so far “behind the curve.”

Instability is pronounced, credit defaults are on track to rise in North America, Europe, Asia, and Australia, according to a survey by the International Association of Credit Portfolio Managers. The economic slump is likely to occur later this year or in 2023, according to the survey.

Global Bonds 2022 Performance

10 Year Bonds – Americas 2022 Performance

10 Year Bonds – Europe 2022 Performance

10 Year Bonds – Asia 2022 Performance

10 Year Bonds – Africa 2022 Performance

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Sources: Scotia Bank, TC, FT

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