The CIO’s Take:
With US stocks trading fairly flat over the last week, the most exciting action turned out to be in the bond market, where surging Treasury yields pushed fixed income funds further into the red, extending a record drawdown in US bonds and prompting huge contrarian flows into iShares 20+ Year Treasury Bond ETF (TLT). We suspect that this is not a capitulation in the Treasury market, overshooting to the downside and now priced for a reversal. To the contrary, the entire reason Rayliant held off on increasing our models’ fixed income duration and that we haven’t yet pulled the trigger is that we still have strong conviction in the fundamental factors motivating a repricing of long-term rates—indeed, we’ve been warning about it for months—and we don’t see changes to those dynamics on the near horizon. Instead of fighting that trend, we’re focused on understanding where else across markets it’s likely to show up, positioning our models to benefit as the story continues to play out.
10-year Treasury prices plummet
We’ve often commented that one of the biggest determinants of market action in recent months has been Fed policy, and it’s why we’ve spent so much time breaking down FOMC policy rate decisions and the data driving them. In the last few weeks, however, many investors have turned their attention to a different rate, one that the Fed doesn’t directly control: the yield on long-term Treasuries. What has markets concerned recently is how fast the 10-year Treasury yield has been climbing, breaching 4.6% last week, a figure last observed 16 years ago, in 2007. To put that into perspective, in the midst of the initial pandemic shock, long-term Treasuries yielded below 1%. This huge rise in rates has led to big paper losses for many bond investors and prompted concerns over a hard landing as the ramifications of higher long-term rates ripple through the real economy.
Inflation isn’t driving yields higher
So, what’s responsible for this surge in Treasury yields? It doesn’t appear to be a belief by investors that future inflation will be especially high. We can see that by comparing the yield on standard long-term bonds with that of Treasury inflation-protected securities (TIPS), as in the chart below, which plots the “breakeven” rate of inflation that bond prices imply investors are expecting to see in the long run.
Inflation expectations have actually been coming down a bit over the last couple years, hovering just under 2.5% in recent months. Real yields are simply going higher. Fed chair Jay Powell, when asked at the FOMC press conference last week why bond yields were rising, bluntly confirmed that “it’s not because of inflation.” Instead, as we’ve been predicting for some time, higher yields are an almost inevitable result of investors understanding of supply, on the one hand—e.g., the massive pile of US debt, with much more Treasury issuance to come—and prospects for US growth and longer-term Fed policy, on the other. Referencing these alternative narratives in his comments to the media, Powell himself offered that “the common explanations that you hear in the markets kind of make sense.” We agree.
An unpleasant return to high rates
A large subset of investors who have only ever known zero interest-rate policy will be forgiven for imagining that long-term interest rates at this level are something new. In fact, 4.5% yields on Treasury bonds are actually the average set over more than two centuries, making the last couple decades of easy money the real anomaly. Unfortunately, the comedown from super-accommodative policy could be jarring. That certainly goes for US fixed income investors, who entered the 38th month of their present losing streak: the longest one since at least the mid-1970s, when the Bloomberg US Aggregate Bond Index launched. The longer one’s bond duration, the worse it’s felt, with the famous iShares 20+ Year Treasury Bond ETF (TLT) recently posting its biggest-ever drawdown, declining 48% from its 2020 peak. In the real economy, the cooling consequences of higher long-term yields are also looming, with everything from households’ mortgage rates to corporate America’s borrowing costs hinging on where 10-year Treasuries settle.
Some investors bet on reversal
Interestingly, despite the huge drop in TLT, which reached its lowest price since 2011—and despite the fact that comparable yields are available without taking such big duration risk—there are plenty of speculators piling money in on a contrarian trade backing long-term bonds. Inflows to the ETF just last week injected $750 million of assets. We imagine a good chunk of that is retail money, but Commodity Futures Trading Commission (CFTC) data on derivatives traders’ commitments show institutional asset managers also making a bullish bet on 10-year Treasuries, with futures contracts that gain if yields go down and prices go up reaching a level not seen since the Global Financial Crisis. Does that mean it’s time to join the herd and extend duration? With signs pointing to heavy supply and weak demand, and given the Fed’s restrictive posture, we think there’s likely more pain in store and favor quite compelling yields on short-term Treasuries.
USD rebounds on growth, Fed policy
There are other implications of shifting beliefs about the FOMC’s policy trajectory. In the latter half of 2022, investors were pretty much convinced Fed tightening was nearing its end and we would see a quick pivot to rate cuts. In that scenario, with less capital rushing into Treasuries, there would naturally be less demand for the dollar, and many thought the greenback’s rally of recent years was bound to reverse. The tide turned rather dramatically since the middle of summer, as US growth surprised to the upside, investors increasingly took heed of the Fed’s hawkish messaging, and pessimism grew toward China’s stalling recovery and Europe’s stagflationary predicament. As a result, the dollar has moved abruptly higher against most major currencies during the third quarter (see below).
International costs of dollar strength
Clearly, not everyone will be cheering a resurgent dollar. Emerging economies, in particular, will be back to fretting over the increased cost of servicing USD-denominated debt, as well as the risk of having to scale back on their own plans for easing in 2024, as higher-for-longer US interest rates have the potential to crowd out capital allocation to emerging economies. There’s also a more direct effect of USD strength on emerging economies, many of which are heavily resource-driven, whereby demand for commodities settled in the dollar takes a hit as USD appreciation makes those goods more expensive to importers. Unfortunately, it’s not just EM commodity exporters who will be hurt by dollar strength as volumes retreat: developed countries grappling with persistent inflation—including the UK and Eurozone, who also face the ‘double whammy’ of contracting growth—will see higher commodity prices resulting from a strong dollar exacerbating their already impossible policy situation as energy and raw materials costs soar. In this way, somewhat ironically, at the same time the US economy’s prospects brighten, it also effectively offloads part of its inflationary challenge to the rest of the world.
Share repurchases take a hit in Q2
Prior to the pandemic, there was quite a bit of financial media attention focused on stock buybacks: the process by which companies purchase their own stock, reducing the count of their shares on the market. While some observers have criticized a wave of stock buybacks in recent years as a sneaky attempt by managers to boost their firms’ earnings-per-share by shrinking the denominator, rather than working to expand earnings in the numerator, others have pointed to repurchases as a bullish signal, potentially indicating managers’ confidence that their own stock is undervalued. After all, why would they waste the company’s cash to buy shares if they thought the price was too high? Those adopting the latter stance will certainly have taken notice of Standard & Poor’s latest share buyback report for Q2 2023, indicating a 19% quarter-over-quarter drop in the volume of share repurchases (see below). Should we take this as a sign that American CFOs are worried their firms’ shares may be trading a bit too high?
Higher rates likely to blame
It turns out the decline in buybacks by US firms likely reflects yet another delayed consequence of aggressive tightening by the Fed over the last eighteen months. When a company sits on a pile of cash, there are plenty of things they can do with it, including buying back their own shares. As mentioned, they might want to do that for a number of reasons, including trying to boost EPS, but also simply returning capital to shareholders by more tax-efficient means than a cash dividend. Of course, when rates are higher, the value of cash is higher, and the opportunity cost of a buyback naturally increases. In that sense, it’s not surprising to see companies rein in repurchases as rates rise—perhaps even electing to plunk their cash into more attractive Treasuries. For companies without money to burn on buybacks, if rates are sufficiently low, it can actually be attractive to borrow and use the proceeds to repurchase shares. But it’s hard to see many companies wanting to do that after 525 bps in Fed hikes. Meanwhile, some of the biggest players in the buyback game, including companies like Microsoft, Apple, Alphabet, Exxon, and Chevron, have strong enough cash flows that their repurchases may continue despite surging interest rates. All in all, this suggests investors ought not read too much into the recent softening in repurchases.