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To put the recent bond market rout into perspective, the drawdown in the US Treasury market has been greater than the equity market drawdown experienced during the Global Financial Crisis of 2008. That’s some feat, given that bonds are typically the least volatile asset class, and hence an important hedging asset for equity portfolios. But most importantly it also suggests the level of pain being experienced in bond portfolios. 

It is also interesting to note also how US treasuries have defied most sell side forecasts for 2023. At the turn of the year the majority of fixed income strategists saw 10-year US Treasury yields much lower than where they closed at the end of 2022. To be fair, this was based on the view that a global recession would eventuate this year. It’s yet to arrive.

Ultimately however, the rise in yields isn’t reflection of recessions ‘non-arrival’, or either, a higher inflationary environment. Sure a ”higher for longer” policy setting by the Federal Reserve has played a role in driving yields higher, but something more structurally fundamental is at play. At Substantive Research we’ve followed the astute analysis of several independent analysts who have explored these structural flaws in debt markets their research over 2023. Their concerns about debt sustainability, and the changing supply and demand dynamics have proved prescient. What do they think now? What are the current forces at play? What can policy makers do to put a cap on bond yields?

We include their most recent analysis below.

Forest for the Trees: The global sovereign debt bubble is popping due to the convexity of net effective UST supplies

For more than 2-years Luke Gromen from Forest for the Trees has made the case that the US Treasury market was on shaky ground. It’s been a thesis based on a fairly solid rationale, but which few were willing to entertain. Gromen’s views was based on a confluence of factors, both on the demand and supply side, but it’s firmly grounded on the idea of debt sustainability (or unsustainability) and it challenged the consensus view that US Treasuries were the asset of last resort for investors. As US Treasuries have hit the wall of a hawkish Fed, Gromen thinks the chickens have finally come home to roost. In this excellent note, Gromen reexamines these risks, digs into the current market dynamics, including some disadvantagous positioning and provides his thoughts on how investors should position themselves as the debt bubble bursts. Click here for the full note.

Macro Risk Advisors: Bond market drawdown surpasses GFC equity drawdown; How to stop the bleeding

Shocking fact: The US Treasury drawdown is now greater than the equity drawdown was during the GFC. it helps illustrate the degree of pain being inflicted on the back end of the yield curve. MRA’s Barry Knapp walks investors through the risks in this short video, pointing out that option markets are reflecting the shift in uncertainty from the front end to now the back end of the curve, as reflected in the spike in long-dated swaption volatility. As Knapp says, two policy pieces exacerbating each other, that is, the Fed, via its ”higher for longer” policy, which is keeping the curve inverted, and the increased supply, reduced demand factor. This spells trouble for market. That’s because the natural buyers of US Treasuries today are banks and hedge funds, and given they are leveraged players, an inverted curve makes this highly unlikely. That then means, as yields rise, the debt servicing costs for the US government spiral, leading to further supply int the market. It’s a toxic mix. Click here for the full note.

Quant Insight: Rising bond yields; what breaks next? 

The back-up in bond yields is reaching that point where global investors are wondering what breaks next, according to Quant Insight. History has taught us that moves like these often end with some kind of financial accident, says the firm. This short video showcases how Qi can give multi-asset investors a ready reckoner; a quick way to identify which pockets of the market are potentially most at risk. The video shows how a Watchlist can be created with your curated list of assets that you deem the best proxies for financial stress. And how that list provides a quick and easy way to eyeball where: macro conditions are important; which assets are already pricing in bad news; and which assets are potentially complacent and therefore vulnerable. Click here for the full note.

Trahan Macro Research/RSA: Higher yields and a looming mortgage crisis; an NYC case study

To pick up on the Quant Insight piece above, Francois Trahan flags up a startling piece published by RSA, or Rent Stabiliazation Association of NYC, the largest trade organization in New York City which is dedicated to protecting and serving the interests of the residential housing industry. Click here for the piece.

Trahan has kindly summarised the piece for us below.

It’s estimated that of approximately $4.4 trillion of outstanding commercial/multifamily mortgages, $728 billion (16%) matures in 2023 with another $659 billion (15%) maturing in 2024.

New York City, having among the most multifamily buildings in the country, is especially vulnerable to disruptions and turmoil in this market. These mortgages are overwhelmingly short-term loans, as is typical in the multifamily / apartment building economy. These aren’t the 30-year fixed mortgages that single family homeowners get.

All of the billions of dollars in multifamily loans coming due were taken out at much lower interest rates. Current higher rates – double previous rates, or more – have been steep, quick, and across all parts of the economy.

Regional and midsize banks hold a lot of these loans, as they are typically the lenders closest to the ground and more active in local residential real estate. The exposure of these banks, in apartment buildings and other local businesses, is extreme and puts them in a precarious position. If they stumble or fail, as some very publicly already have, it is the federal government and the taxpayers on the hook for the bailouts.

CrossBorder Capital: Not yet a credit crisis; QS could become the new QE

Michael Hewitt from CrossBorder Capital is a renowned expert on global liquidity, and so his work at this current market juncture is required reading. The uniqueness of CrossBorder’s analysis is not just its unparalleled understanding of the plumbing that underpins global liquidity, but the vast proprietary data sets that they have to track liquidity on a real time basis. As they remind readers in this note, liquidity needs to expand hand–in–hand with debt to support rising debt levels: more debt requires more financing, and, without extra liquidity, crises occur.

Unless the US authorities do something to cap rising yields, the current duration crisis could turn into a more worrying credit crisis. The liquidity solution, say CrossBorder, could come from a new version of Quantitative Easing.  They say all efforts will be made to avoid calling this ‘QE’. How about QS – quantitative support – as the new acronym? CBC muse. They say that at this year’s Jackson Hole Conference, Fed policymakers began finessing the important distinction between straight monetary policy and market support operations. This may provide the excuse to ‘print money’. CBC say investors must think seriously about owning monetary inflation hedges, such as gold and cryptocurrencies. Equities may keep pace in the long term, but bonds remain high risk. Click here for the full note.