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Markets love Goldilocks. Everything just right. Not too hot, not too cold. Not too hard, not too soft. Just... Optimal. Stock markets head higher, bulls make money and all is right with the world.

Until the bears come home and eat Goldilocks (or set her on fire)...

Genuinely, if you're a stock market bear, grab your tissues and lotion. You're gonna LOVE this fairytale.

Am I overselling it? Must be the only thing around here that's oversold lads, eh?

OK enough of that. There's something I genuinely want to chat about.

I don't really know what to call it though... A tail risk, a potential grey swan event. The inevitable consequence? Seriously, no idea. You decide.

First up, some context. Despite my recent bearish writings, I generally think the default setting for stocks is always up. Sometimes fast, sometimes slow. Positive drift is a thing, and being long stocks generally has a much higher expectancy than being short.

The Infinite Bull Market
Can indices really just keep rising? Yes. (in the long run)

Which is why I tend to focus on the risks... i.e. When might this default setting not apply?

Onto my big bad bear thesis. It's a little convoluted (usually means higher odds it's wrong) while also being quite simple...

I'll show my workings properly so that you can pick it apart, and/or completely fade it, then summarise at the end.

The basic premise: "What if long term bond yields rise?"

Let's start with why they might rise.

Reason 1: I've started so I'll finish

In theory, a healthy yield curve is supposed to be positively sloping. If you lock up your hard-earned savings in an investment for a month, you 'should' get a little bit of interest.

If you lock those savings up for a decade, you're supposed to get a better return, or what the nerds call a 'term premium'. If the why isn't obvious, look up the time value of money.

That's not the case right now. Instead, we have a deeply inverted yield curve.

Cash and shorter duration instruments are yielding far more than longer dated ones.

Soooo, maybe we do the bear steepener thing (long term rates rise faster than short term rates). πŸ“ˆ

In this case, short term rates would stay anchored (based on belief that Fed is done for a while - no hikes, no cuts), while longer term rates catch up...

There's a bit of a fly in the ointment here. Inverted yield curves have tended to precede recessions, usually when the curve returns to positive territory...

But that's a problem for later.

Mechanically, inverted curves are only sustainable for a limited time. The whole point of lending over a longer term is to receive a higher future return. If cash is more attractive, the incentive to lend is far lower, so credit availability tends to tighten up until/unless the risk is compensated with a better yield.

There's two main ways to resolve the curve inversion. Rate cuts at the front end (because everything's bad, Fed cuts rates) or higher long term rates (because everything's going great).

Which brings us nicely to...

Reason #2 - Soft Landing Or No Landing, Just Keep Flying

Imagine that US economic strength continues/maintains. Fiscal spend continues flowing through the economy. Inflation settles into a happy range either side of 4% and unemployment remains low.

Why buy (for example) 10y bonds with a yield of 3.95% when you can buy 1 year bills instead and get 5.4%?

Although there's a load of maths and roll structures in bond trading, it doesn't take a genius to see that locking up your cash for a longer period and lower return doesn't errr, math very well.

πŸ“” The ULTIMATE guide to bond trading
The ULTIMATE guide to bond trading

Unless of course, you think that none of this is sustainable. That the economy will soon fall apart and the Fed will drastically cut rates in response. If you're right and nail the timing, happy days. Well done you.

But the market isn't pricing this at all. Not even close.

If we presume that 10y/30y yields stay at 4%, there won't be a flat or positive curve until at least December 2024 based on current Fed hike/cut pricing...

If the economy is strong enough to last until March 2024 (or beyond) without rate cuts, the incentive to really pile in to longer bonds is low.

Reason #3 We Just Want Yer Money...

The US Treasury, represented here by Phat Bollard 🎢

Later today, the US Treasury will tell us how much they need to borrow this quarter. This is nothing new. They do this every quarter, and most of the time it's just an event for bond traders, (but if longer rates rise, what does that mean for stocks...?)

The Treasury will release its quarterly borrowing requirement Monday afternoon, and its refunding news comes Wednesday at 0830 ET/1230 GMT - Reuters

The refunding structure could matter. Of late, the Treasury has preferred to sell bills (1 month to 1 year maturity), but that looks to be changing...

... to keep the proportion of bills within the recommended range of its overall debt load, the government will also need to increase the size of coupon-bearing debt sales

Which, potentially shifts the issuance out to longer maturities (anywhere from 1 year to 30 year is usually coupon bearing).

Meghan Swiber, a rates strategist at Bank of America says this will be an ongoing theme...

"They have to grow coupon auction sizes - not just at the August refunding, not just at the November refunding, but also at the February refunding as well, because they are ultimately trying to balance this supply picture between bills vs coupons and this growing financing need,"

So, potentially more supply of longer dated notes and bonds, less supply of shorter dated bills.

Reason #4 - Japan's Doing Things

The Bank of Japan's in the process of widening their 10 year Yield Curve Cap to 1%. Japanese bond yields are rising from the prior 0.5% cap now, while the BoJ is trying to smooth the path.

Which, at the margin, changes the attractiveness of foreign bonds, especially once currency hedging costs are accounted for.

These guys know way more about bonds than I do, so I listen to them... πŸ‘‡

Basically, currency costs are eating most of the returns. So, Japanese government bonds (yield hit 0.6% earlier today before the BoJ stepped in to calm things down) are becoming a better deal for Japanese investors.

Which means Japanese demand may go missing just as the US Treasury is increasing issuance (supply)...

What will make those bonds more attractive to Japanese investors?

A more favourable exchange rate (lower USDJPY), or higher yields on those overseas bonds...

Bloomberg frame this as a $3 Trillion Threat to Global Financial Markets Looms in Japan

50 trillion yen is roughly 350 billion USD

And speculate that it could lead to more Japanese flows heading home...?

β€œYou’ve already seen the start of that money being repatriated back to Japan,”
β€œIt would be logical for them to bring the money home and not to take the foreign exchange risk,” - Jeffrey Atherton, portfolio manager at Man GLG, part of Man Group.

Don't think of this in absolutes. It will likely play out over months. It could be a massive nothingburger, but keep an eye out for cross-asset implications.

Investment markets are always competing for capital.

If the US Treasury is increasing supply while Japan's pulling back from buying Western assets (maybe even selling too) due to currency costs and higher domestic yields, that's a potential double whammy that can spill over into credit, stocks, and so on.

The US 10 year rate is essentially a benchmark for valuing every asset. If that rate heads higher, assumptions will be questioned, positions will be changed, models will be updated, and fun will be had by all.

Why? Because it changes the 'risk free' rate. Which would mean the bar for returns on riskier investments (credit, stocks etc) is likely to shift higher...

Nothing's certain here. It may be that the mere suggestion of higher for longer across the entire curve is enough to see credit dry up. Tonight's lending officer survey (SLOOS) will offer some clues on recent appetites.

Oh, and Goldilocks hasn't always been a cute children's story with a happy ending...

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