A widely expected move higher in bond yields has yet to materialize in 2014, and those expectations actually may help explain why yields have declined. Financial markets occasionally “zig” just when a growing majority expects a “zag.” Bonds are no exception, and many investors have been caught off guard by early 2014 bond strength. Although profit taking hit bonds on Monday, January 27, 2014, the Barclays Aggregate Bond Index is still up over 1% year to date. After dropping as low as 2.71% last Friday, the 10-year Treasury yield closed Monday, January 27, 2014 at 2.76%, still 0.27% lower in just over three weeks of trading this year — a significant move.
Lopsided sentiment can often drive contrarian moves by financial markets, especially in the bond market. One indicator that captured the overwhelmingly negative sentiment on bonds was the Commitments of Traders report, which is issued weekly by the U.S. Commodity Futures Trading Commission (CFTC). The CFTC Commitments of Traders report includes the net positioning of speculative investors across a variety of futures contracts. Observing whether speculative investors are net long (betting on higher prices) or net short (betting on lower prices) can reveal positioning of institutional speculative investors.
In late 2013, the CFTC report showed one of the largest net short positions on record in 10-year Treasury futures, indicating that the market was expecting rates to rise. The near 200,000 net short position was a level witnessed only rarely over the past 10 years [Figure 1]. These extremes have
often coincided with contrarian rallies as evidenced by the shaded areas. As prices rise and yields decline, speculative investors scramble to cover their short positions for fear of incurring losses. The rush to exit positions can be a powerful force and, here in early 2014, the subsequent buying has helped propel the bond market higher.
This contrarian indicator can help explain pullbacks as well. The buildup of long positions in early 2013 to some of the highest levels of the past few years coincided with the 2013 bond pullback and rise in yields.
At the same time, the indicator is not foolproof, and a significant net long position prior to the 2007 – 08 financial crisis coincided with a long decline in yields. In addition, the CFTC data are released with a slight lag meaning sentiment may have shifted, but it does help explain market moves. The CFTC report is just one tool to assess sentiment that may be offside and a lead to a contrarian move in the markets, but it needs to be evaluated in conjunction with other data.
Positioning
Positioning of short-term speculators is far from the only factor driving bond prices, and investor positioning appeared to corroborate the negative sentiment at the start of the year. The firm Stone & McCarthy Research Associates conducts a survey of bond investors to assess whether they are positioned short, neutral, or long relative to their broad benchmarks. A short or long bias would reveal investor expectations of rising or falling interest rates, respectively. In mid-January, Stone & McCarthy’s survey revealed investors on average were at 96.6% of their target interest rate sensitivity, or duration, the most defensive reading since the third quarter of 2008.
As bond prices rise and interest rates fall, defensively positioned investors may see their portfolios likely lag benchmark performance. Investors then would likely buy to get closer to their benchmark in order to limit underperformance to a benchmark. Bond buys to get portfolios closer to neutral may have aided bonds in early 2014.
When coupled with fundamental drivers, positioning and sentiment can be a potent combination. In early January 2014, a weaker-than-expected employment report sparked questions about the strength of the economy and bonds rallied, setting in motion a buying spree as wrong-footed investors reversed bets on lower bond prices. Pension investors also took advantage of yields near two-and-a-half-year highs and also gave bond prices a boost to start 2014 (please see blog post Why Own Bonds? 1/21/14 for more details).
Recent momentum was aided by a host of emerging market (EM) issues spurring buys of higher-quality assets like Treasuries. Weaker-than-expected economic growth from China, Turkey’s central bank’s attempt to stabilize its currency, political instability in the Ukraine, and Argentine currency devaluation all contributed to US Treasury demand.
EM currency fears appear contained for now, however, with no signs of disruption in domestic intra-bank lending markets. The TED spread, a key gauge of inter-bank lending pressures during the 2007 – 08 financial crisis and several times during the European debt fears of recent years, has served as an early warning signal but is near a post-recession low for now [Figure 2], indicating no global contagion from EM currency weakness.
Where Do We Go From Here?
Although EM concerns may support high-quality bonds during the current week, the offside positioning in the bond market has been largely reversed. Figure 1 illustrates that while speculators may still be net short, positioning is much closer to neutral and away from an extreme. The most recent J.P. Morgan investor duration survey shows fewer participants “short” and a greater number now “neutral.”
This suggests that the fuel for additional price gains will likely need to come from fundamental data. The preponderance of economic data suggests the U.S. economy continues to expand near our expected pace of 3% (as measured by real gross domestic product) and that the weak employment report may have been an outlier, suggesting further bond gains may be limited. Bond investors may refocus on economic data now that positioning and sentiment appear more balanced.
Furthermore, this week’s auctions of new two-, five-, and seven-year Treasury securities may give investors pause after the recent run-up in prices. Add a Federal Reserve (Fed) meeting, and a bond market breather is likely until new information is digested. The Fed is also widely expected to announce a further $10 billion reduction in bond purchases at the conclusion of Wednesday’s Fed meeting. Both factors augur for higher yield probability over the course of the year.
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IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. Past performance is no guarantee of future results.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.
Treasuries are marketable, fixed-interest U.S. government debt securities. Treasury bonds make interest payments semi-annually, and the income that holders receive is only taxed at the federal level.
Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.
International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
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INDEX DESCRIPTIONS
The Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
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This research material has been prepared by LPL Financial.
To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.
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