The current Treasury bear market has been impressive, and unfortunately for the bond bulls, there is no valuation reason for it to stop. For example, the 5-year Treasury is still trading well below the overnight rate. If we look back to the 1994 bond bear market, the 5-year traded about 250 basis points above cash — versus about 100 basis points below now.
The explanation for this disparity can be pinned on the Fed reaction function. Back in 1994, the memories of the Volcker Madness were fresh, and so the curve extrapolated a lot more rate hikes. However, inflation proved to be more subdued than feared, and so rates reversed and continued the secular bull market. A couple of decades of tight fiscal/labour market policy along with New Keynesian central bankers resolutely pushing on strings led to coupon yields remaining more subdued, tending to discount future panic rate cut cycles. To break out of the downtrend of lower policy rates, we needed shifts to policy that broke the stagnation of the labour market that characterised the post-1990 era.
Without even looking at term structure models, my guess (based on past model behaviour) is that all the volatility in recent moves was the allegedly the result of the term premium changing. That is, the term premium did a V-shape move in the past few months, falling then rising. The problem with this interpretation is that the term premium is so unstable that it is not helpful — instead of just trying to outwit the raw (risk neutral) forward rates, one is now fighting against a mobile term premium and “unbiased” expected rates. Admittedly, having a term premium move around adds more scope to commentary about rate moves, but providing fodder for newsletter letters is not necessarily helpful for understanding the world.
Once again, I am not offering any forecasts as to where rates will go. However, it is safe to say that in the absence of a near-run recession, owning bonds trading through the policy rate tends to be painful.
Anyway, I am back from my travels and looking at my manuscript. It is getting there, although I still have to decide whether to tone down my criticism of the hard money nuts. For those of you unaware of the premise of the book, it is a basic primer of inflation facts — without spending time endorsing any theories. The idea was that if I lumped theory and facts into a single book, the complex hand-wringing about theory would distract people new to the field away from basic concepts like the CPI actually includes food and energy (one of the sillier bits of misinformation I see repeated). The misinformation about inflation tends to come from the hard money crowd, but I might need to cut down the repetitions of that observation throughout the manuscript.
As a final note, I migrated my Mastodon account, as the econtwitter server is shutting down. My new handle is: @[email protected]. People following me appear to have been migrated automagically. I do not post too much on Mastodon, but I put my article links up there.
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(c) Brian Romanchuk 2023