Bonds Nosedive and Suffer Worst Week Since 2016
It’s not that we didn’t see this coming, but the buying frenzy that sent prices of U.S. treasuries to historic levels had to come to an end sooner or later. Sooner is here.
While fundamentals do play a lot bigger role in the bond market than they do with the stock market, momentum still plays a role with bonds as well, and we sure got a chance to see how much of a role this can play this year.
It’s not that the fundamentals, how the economy is doing where bonds are concerned, haven’t been kind to bonds over the past year, but they simply haven’t been kind enough to drive prices of bonds up anywhere near as far as we have seen them.
It’s been no secret that the demand itself for treasuries has really picked up this year, and when treasuries are hot, this does attract momentum. The increased interest in treasuries that got this whole train started is only part of the story, as this has presented some great trading opportunities for bond traders, especially those that use a lot of leverage like institutional investors do.
The iShares 20+ Year Treasury Bond ETF was up 26% year over year in late August, which is a phenomenal amount for a treasury fund. When treasuries produce returns like this, you know they are hot, and they have been hotter than hot over this time to be sure.
The key to this move has been the inelasticity of the underlying demand that has helped drive this, where traders drive prices up even more and the lineup to buy more in the background remains. We have already seen how inelastic bond markets can become in Europe, where negative yields haven’t even put a lid on this.
This is not something that can be sustained though, especially since this is so historically unusual. In August, treasuries really rose in price, until we started bumping against all-time low yields which did serve to restrain the market.
This was also a time where some, including us, warned of the risks of the party ending and investors being prone to some real losses. As it turned out, we got a real taste of this during the last week.
Treasuries Have Taken a Real Tumble This Week, a Stock Selloff Sized One
The iShares ETF that tracks long treasuries is now down 7.4% over the last 6 trading days, with 6.2% of the loss coming this week. This is the biggest one-week loss since November of 2016, which was another situation where prices rose by a lot and then started to come down.
To put this into perspective, this involves an even bigger loss than we saw with the stock market in May, the worst month we’ve had for stocks, and that even took a whole month to materialize, not just a week. Anyone that thinks that bonds can’t go down pretty quickly as well as stocks should have their illusions well dispelled by this move.
The fact that we haven’t lost 6% in a week for almost 3 years is also telling, as this is not a normal occurrence, but seeing the price of treasuries move up as much as they did is also not common. The bigger the spike, the bigger the reversal tends to be as well when things end up eventually settling down.
On the sell side of treasuries, traders play a big role, and many of these positions were not held for the long term but only to ride this fast running horse. When the horse stops, and especially when it turns and starts moving in the other direction, this is where these people get off, adding to the downward pressure on price.
This happens with stocks as well, but some people don’t expect a move like this with bonds and can end up pretty startled. They might brush it off but later, when they are looking to sell, they will more likely notice how much they will get for their securities, and may be disappointed.
Anytime you are not going to hold bonds to maturity, this means that you will be selling them prior to that, at whatever price the market decides that they are worth at the time. We’ve just come off of an all-time high, which was precipitated by a very unusually high level of demand for them, and we need to realize that we might not even get back to where we were in August for a long time, if we ever do get back there.
Whenever we analyze an investment, we need to look at both the potential return and the potential risk and decide whether the potential return is worth pursuing and taking on the risk to do it.
If we were back to last fall, when prices started to pick up and there were actually people fleeing the declining stock market to get into bonds more, the risk at this point of being long treasuries would have been low with the potential returns being attractive.
With all the talk on the street about things starting to deteriorate, this was indeed a good time to be in bonds generally, and the rally in the bond market corresponded with the fall in the stock market, but this was not surprising.
Treasury Prices are Still Too High Even After Dropping 7% Lately
Today we’ve run up all this much, and in a way that really doesn’t correspond with the fundamentals. If things were bad and we went up a lot, that at least would be on firmer ground than one that has overstated the situation if we use fundamentals as a guide to where the bond market should be.
People were loving U.S. paper a lot though but even demand as unshakeable as this has been in 2019 still has its limitations. It is being shook as we speak. If we compare where we are now to where we were last October, there was a lot of upside and limited downside, there is limited upside and a lot more downside now, which is not at all desirable.
People who bought treasuries in August didn’t just have the low yield to worry about, as the bigger problem was that these low yields meant that the price had been bid up that much and what has been bid up too much will tend to reverse its course.
That’s exactly what we’re seeing right now with treasuries and even a 7% pullback may not be enough to correct the situation and have us wanting to be back in them. This could continue for a while longer actually, and another 7% wouldn’t even be that big of a surprise as this would just take us back to where we were at the end of May, as that’s how far we came from June to August.
It’s not even that clear how much further treasuries would need to come down before we could say that they were oversold, but this particular run-up over the summer really wasn’t based upon much other than just pure enthusiasm, so when this enthusiasm wanes, the fair-weathered friends will be leaving the party.
Should prices drop further, this may continue the momentum and we may indeed reach a point where they become oversold, as happens quite often with corrections. At that point, we might want to look to get back in if we wish to hold treasuries, but as we can see, when we hold them matters and can matter a great deal, as it clearly does now.
Whether we should enter a position or stay in it involves the same process, or it at least should, because an investment is either desirable or not. If it is not desirable to want to buy, it is not desirable, and we should seek out desirable ones and exit ones that aren’t.
Treasuries still look too risky right now, and the risk that we would take on if we buy is the same as what we take on when we hold. Should the selloff continue though, and give back half of its 2019 gains or more in total, this would both reduce the risk and increase the upside for being long treasuries, and make both buying and holding treasuries more attractive.
Editor, MarketReview.com
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