A Case Of Bond Market Indigestion

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Whether this summer’s runaway ascent of bond prices was mainly a flight-to-safety response to global trade fears or a “follow the leader” move on the part of momentum traders is a subject of fierce debate among traders. What matters most, however, is that after the market hit a peak a few months ago, bond prices – especially Treasuries – continue to weaken. In this report, we’ll discuss some reasons which suggest that the “indigestion” that both the corporate and the U.S. Treasury debt markets are suffering isn’t over yet. I’ll also explain why equities will likely take precedence over bonds in the coming months.

In many ways, 2019 has been a banner year for bond traders. While many pundits insisted that the relentless rise of the U.S. Treasury bond prices, and corresponding drop in yields, was the result of a “bubble,” the fact is that fear was the primary motive behind the bond rally. Investors eagerly sought out the safest possible alternative to equities for their money and naturally enough turned to the Treasury market. Persistent dread over the U.S.-China trade war, which at times bordered on panic, helped push T-bonds to levels not seen since the near-recession year of 2016.

Investors’ insatiable hunger for safety is perhaps best reflected in the following graph which shows the almost vertical path of the iShares 20+ Year Treasury Bond ETF (TLT). Price moves which travel straight up are bound to be followed by equally sharp corrective declines and consolidation periods. Following its strong performance earlier this summer, the Treasury market simply ran out of steam and needed a period of rest.

Source: BigCharts

The fact that the decline in Treasury prices started around the time that the U.S. and China began making overtures toward ending their tariff dispute was no coincidence, either. On Nov. 7, it was announced that both countries had agreed to roll back tariffs on each other’s goods in the event that a trade deal is completed. This announcement was greeted with consternation by bond traders, and the result was seen in the price drop for the 10-year Treasury note along with an impressive 6% rally in the 10-Year Treasury Note Yield Index (TNX).

Source: BigCharts

In my previous bond market commentaries, I’ve made the case that Treasury yields are likely to gradually rise in the coming months as trade war fears diminish. Risk aversion should decline as investors warm up to the much-maligned equity market, now that the prospects for global growth look better. Another consideration is that the red-hot BBB-rated corporate debt market is still likely suffering a case of “indigestion” after this summer’s runaway rally. Now that the “fear factor” is waning, traders should expect to see a much more sluggish market for corporate debt.

Here is what the Vanguard Short-Term Corporate Bond ETF (VCSH) looks like as of Nov. 7. This is one of my favorite proxies for the overall corporate debt market, and as you can see here, VCSH remains stuck in a lateral range below its late August high and its mid-September low. With short-term corporate bond prices currently neutral, institutional investors now have an additional incentive to turn their attention toward the stock market.

Source: BigCharts

It is, however, a fair assumption that higher grade corporate bonds won’t suffer the same degree of liquidation as Treasury bonds in the coming weeks and months. Despite record issuance of new BBB bonds in 2019, credit conditions continue to support the overall U.S. corporate profit outlook. This will ultimately translate into higher stock prices, but it will also likely result in continued strong demand for quality corporate debt. Thus, bond investors need not be overly concerned about the prospects of a bear market in corporate debt.

Below is what the Bank of America Merrill Lynch U.S. Corporate BBB Option-Adjusted Spread looks like. This reflects the fact that there are no real worries among the largely informed (i.e., “smart money”) corporate bond crowd over the U.S. economic or corporate profit outlook. Moreover, tighter spreads suggest that corporate bond prices are still attractively priced relative to government bonds. Thus, in the bond market realm, expect participants to favor corporates over Treasuries in the coming months.

Source: St. Louis Fed

That said, short-term-oriented bond traders should probably think twice before initiating any new corporate debt purchases. The following indicator shows the 4-week rate of change (momentum) of the new highs and lows of 50 of the most actively traded U.S.-traded corporate and Treasury bond ETFs. I use this tool to evaluate the near-term path of least resistance for the overall bond ETF market. As you can see, this indicator hasn’t yet turned up enough to suggest that a bottom is in for corporate and Treasury bond prices. Until it does, conservative traders and investors should hold off before initiating new long positions in the bond ETF market.

Source: NYSE

In summary, this summer’s bond market peak has been followed by continued deterioration in the sovereign debt market and, to a lesser extent, in corporate bonds. As per my continued thesis, investors should expect that risk aversion will continue to decline in the coming weeks in view of the continued improvements in the global trade outlook. The diminution of trade war fears is also likely to result in higher equity prices and lower Treasury bond prices.

Higher bond yields can further be expected as the U.S. government debt market gradually returns to a more normal state, now that safe-haven demand has diminished. Investors should respond accordingly by increasing exposure to stocks on an intermediate-term (3-6 months) basis while diminishing exposure to government bonds.

Disclosure: I am/we are long SPHQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.