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Bonds Suddenly Look Like a Smart Hedge Again After 12% Loss

Treasuries are starting to look more appealing following the historic stock rout.

(Bloomberg) -- A few brave souls in the investing world are starting to move back into bonds to ride out an oncoming economic storm.

While debt bulls on Wall Street have been crushed all year, market sentiment has shifted markedly over the past week from inflation fears to growth. That theme gathered more strength Monday, when data showing a sharp contraction in China’s economy sparked brief gains for Treasuries.

Market-derived expectations of US price growth have dropped from multi-year highs and nominal yields in the US, Germany, Italy and UK have retreated from recent peaks. Last week’s report showing higher-than-expected price increases for American consumers failed to ignite a sustained rout -- a sign of bear-market exhaustion after a historically bad start to the year. 

With inflation pressures still rampant everywhere, no one is betting with conviction that yields in any of the world’s major markets won’t move higher still. But the argument goes that the asset class still offers a powerful hedge as the Federal Reserve’s aggressive tightening campaign threatens to spur a downturn in the business cycle that could ripple across global assets. 

“We just started buying Treasuries,” said Mark Holman, a partner at TwentyFour Asset Management, a London-based investment firm that specializes in fixed-income securities. “I’m quite pleased that Treasury yields have gone up so much, because I know we are going to need them because we are late cycle.”

Pacific Investment Management Co.’s chief investment officer Dan Ivascyn told the Financial Times that investors should “get ready” to snap up bargain bonds. He pointed to opportunities in higher-quality assets such as mortgage bonds, investment-grade corporate bonds and bank debt, especially of US lenders.

Developed stock and credit markets have fallen this month with economically sensitive trades in the line of fire, helping spur the biggest Treasury inflow since March 2020. While German bunds have rallied sharply of late, they look more vulnerable given the European Central Bank’s tightening campaign has yet to kick in. But that’s not stopping the likes of Citigroup Inc. strategists seeing a reversal in the bund selloff for now as growth concerns trump inflation expectations. 

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“Government bonds can begin to offset risks elsewhere,” said Howard Cunningham, a fixed-income manager at BNY Mellon Investment Management. “We’re not betting that the rise in yields is going to reverse, but government bonds can begin to do a job. Now, you’ve got negative correlation with equities some of the time.”

US government bonds already lost 8.8% this year through the end of last week, putting them on course for their first back-to-back annual declines in at least five decades, according to a Bloomberg index. A global gauge is down more than 12%. Yet the 10-year Treasury yield has fallen 30 basis points since hitting 3.20% on May 9, its highest since 2018. At the same time stocks have dropped sharply amid fears over growth, exacerbated by the war in Ukraine and Covid lockdowns in China.

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Deutsche Bank AG’s Gary Pollack warns the Treasury selloff isn’t over given persistent price pressures from rental costs to airline fares. 

“While we expect inflation to fall, the question is will markets be happy where it settles down to?” said Pollack, the head of fixed income for private wealth management. “That’s why I’m a little reluctant to say let’s buy here.”

US 10-year yields steadied Monday after falling as much as four basis points to 2.88% in Asian trading after China reported industrial output and consumer spending dropped to the worst levels since the pandemic. A look under the hood of the derivatives market suggests hedge funds are unwinding bearish Treasury exposures. 

European Lag

Candriam and AXA Investment Managers are among the firms that see US debt as a better bet than bunds for now. The market-implied expectations suggest the Fed will start cutting rates as soon as 2024, after lifting the funds rate to just over 3% next year. 

“We are starting to think about buying Treasuries,” said Nicolas Forest, head of global fixed income at Candriam. “US yields are more fairly priced because the hiking cycle is already taking place. We are definitely lagging in Europe.” The German two-year yield, around 0.15% on Monday, is “too low” given the deposit rate may be 0.25% by year-end, he added. 

The ECB is only expected to start raising rates in July and traders don’t see cuts for at least the next four years. On this trajectory, US bond prices would get a meaningful boost through a Fed easing cycle at a time when bunds face the headwind of tighter monetary policy.

That’s also a negative for Italian bonds. BNY IM recently increased a short in Italian bond futures as the ECB phases out the easy-money era, while BNP Paribas SA advised against a long position. Italian bonds led euro-area declines Monday. 

Bonds in Europe may yet offer opportunities for Mark Healy, a portfolio manager at AXA Investment Managers. He thinks the UK looks like a relatively safe place to be right now, given the Bank of England’s tightening campaign is in swing.

“We’d favor the UK the most, then the US and then Europe, even though we’d probably push back a bit in terms of how many ECB hikes are priced in,” said Healy. “So further down the road, European government bonds could offer value.”

--With assistance from Edward Bolingbroke and Garfield Reynolds.

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