The new world of bonds

Inflation and rising rates are changing the bond world. If we look at the yield charts over the last few months, it is becoming increasingly evident that we are not in a situation to be considered exceptional and transitory, but the beginning of a potential structural change in the market.

We are in a context where the bear market for bond yields, dominant for about 40 years, is beginning to reverse. And in a context like this, bonds are also changing their skin, and we will find ourselves with a financial instrument that will have completely different qualities compared to those we have always considered.

Let's go in order and start from the second observation. How are bonds changing? Many of you will know about the VIX index, commonly referred to as the "fear index". This index measures, in fact, the volatility of stock market prices, and when it rises sharply, it is synonymous with markets where prices begin to fluctuate very widely. There is a similar index in the bond market as well. It was developed by Merrill Lynch and is called MOVE. The index will rise more sharply when there are fears in the market that rates may rise significantly. We now see a comparison over the past decade of the two indices in Figure 1.

No...it's not a typographical error...the index in black, the MOVE, is rising much higher than the VIX. This indicates that a bond in recent months has become much more volatile than a stock. But hasn't it always been the other way around? Until a few months ago it was, but now things have changed. Owners of bond portfolios are well aware of this, and this year they are having lower performances than those who have invested in flexible portfolios (which also contain a part of equities).

Figure 2 contains the chart of the 10-year Treasury yield since 1980. We can see that the market in the last 41 years has always been bearish for yields, but currently, in the last four years, we are already at the second attempt by the curve to overcome the bearish trendline (the first occurred in 2018). This new attempt, shown in point 3, is also characterized by a remarkably high momentum of the curve, which has brought the oscillator into overbought area (point 2), which last occurred 41 years ago in 1981 (point 1), within the last rate hike that then led to the inversion of the curve.

However, we can see that in the last ten years, if we exclude the pandemic event, rates had a trading range between 1.40% and 3.15% (rectangle in green). So as long as the level does not exceed this area, i.e., does not create a new high, we will only have a sideways trend.

But how have rate curves behaved in previous historical reversals? In Figure 3, we can see the history of the curve of 20- and 30-year Treasuries since 1870. The chart has been taken from a study by the well-known technical analyst Martin Pring. Pring is one of the few analysts who have graphically constructed the secular trends of various financial instruments. It is not so easy to recover prices from a century or two ago. In Pring's original chart, the study was about the number of bullish and bearish markets on yields and their average duration. For my part, I added evidence on the duration of reversals, and the spikes in the curve during upward reversals. The original chart can be found at this link. 

We can see that there have been three downtrends and two uptrends.

The last uptrend lasted 40 years, and we are in a downtrend of similar length. The most interesting thing to note, is how the curve reversals occur. You can see that the reversals from top to bottom are made up of peaks (spikes), which reversed very quickly, while the reversals on the upside, are very slow, about ten years, and characterized by strong volatility that creates rapid movements of the curve upwards of two or three points, which then have sudden descents as well: see all the points indicated by "(sp)" in blue. These are very small movements within the graph, but it is constructed with annual data, and therefore this indicates that between one year and the next, particularly important fluctuations in yields could occur (even 2%-3%).

What do these past considerations suggest to us? That for the next period, we are more likely to be in a long, broad sideways market. That rate hikes are likely to be higher than expected, but quick rises could be followed by violent declines. This leads us to consider bonds in the same way as stocks: more volatile than in the past, with time windows in which strong bearish movements make them attractive as the yield to maturity increases. But in unexpected rises they could instead create negative surprises. Strange to think it, but could the buy the dip sell the rip, commonly used for the stock market, also be good for the bond market? On the other hand, we have remarkably high debt that limits the extent of the yield hike, but also a potential commodity super cycle and transportation logistics issues that favour the opposite movement. All these variables can therefore create alternating movements in rates depending on which variable prevails over the others at that moment. What has been written is a bit provocative, but it could still be a perspective to consider in this more complex world. Perhaps those who invest in bonds could be, in the future, a little less “buy and hold” and more tactical.

About the author

Mario Valentino Guffanti is a board member and Head of the Lugano Chapter. He is a financial advisor, technical analyst and researcher based in Milan, Italy. As an author of technical articles and lecturer as well as instructor in technical analysis courses in Switzerland, he is also dedicated to financial coaching through NLP techniques (neuro-linguistic programming).