Some investors and analysts are convinced that fears of an imminent upset may be overdone.
Long-term bonds have been on a tear in recent weeks with yields tumbling more rapidly than almost any other time in the past decade. But the recession signals flashed by these moves may have been exaggerated because of “forced buying” among some investors.
The strong rally in long bonds has made them among the best performing assets of any market in the world this year. They have also caused dreaded inversions of the U.S. yield curve in August: That is where 10-year yields fall below two-year yields, a reliable signal that recession is around the corner.
Some investors and analysts are convinced that fears of an imminent upset may be overdone. A lot of the recent fall in yields has been because some banks, asset managers, insurers and pension funds have had to gorge on long bonds or bond derivatives because market moves have hurt other positions they hold.
This activity is often called “forced buying” since the trades are dictated by pre-existing risk models and investment strategies. “There was a fundamental driver to this move-in yields and that continues to be validated by economic data and the Fed,” said Josh Younger, head of U.S. interest rates derivatives strategy at JPMorgan in New York. “But the signals provided by the rates markets are being amplified by this hedging activity.”
Less than half the fall in 10-year yields during August—the biggest monthly drop in percentage point terms since 2011—was down to fundamental economic reasons, according to Mr. Younger. He figures 10-year Treasury yields that are currently priced around 1.5% are about one-quarter of a percentage point below where they would be without this activity.
One giveaway that hedging activity has been important in recent market moves is that yields in swap markets, where hedging is done, have fallen faster than those on bonds, according to Mr. Younger.
There are several factors driving investors into long-dated bonds. Falling rates and a wave of Americans refinancing home loans means mortgage-backed bonds get paid off quicker than expected. Institutions who owned those bonds—banks, mortgage real-estate investment trusts and fund managers—are pushed into buying longer-dated Treasurys or interest-rate swaps as the quickest and cheapest way to replace the disappearing income.
Buying also comes from pension funds and insurers that sell annuities. When yields fall, their liabilities often grow faster than their assets. That can increase the so-called “duration gap” in their books, which is the shortfall between what they are going to earn on their assets and what they owe to pensioners. To close the gap, these businesses need more long-term assets.
Bets on low volatility in the bond options and futures markets—a trade popular among so-called unconstrained bond funds—can also produce extreme demand for long dated bonds when volatility spikes.
These trades rely on volatility and yields remaining within a limited range. When yields break lower, as they have recently, investors need to rebuild their long-term exposure quickly and rush into government bonds or swap markets to do so, says James McAlevey, head of rates at Aviva Investors in London.
On Wall Street, these effects all have typically obscure sounding names: mortgage bond owners face “negative convexity,” the risk that the duration of portfolios, or the time it takes for an investor to be paid back through coupon payments, could grow or shrink rapidly. Those betting on low volatility can find themselves “short gamma,” which refers to the risk of market losses on short-dated options on longer-term bonds and interest rate swaps.
“The lower we go in long-term bond yields, the more demand starts to increase for certain products: gamma hedging, convexity hedging and closing duration gaps,” said Mr. McAlevey. “You end up with a market that is all buyers and no sellers.”
None of these types of activity kick off a market move, but they can help it gather pace, said Mr. McAlevey. Hedging activity linked to volatility strategies can also create forced sellers when yields start to rise. “Gamma hedging works both ways,” he said. “So a lot of what’s going on is just going to lead to higher volatility.”
The upshot is that without these flows, the U.S. yield curve wouldn’t have inverted and there would be much less fevered chatter about a coming recession.
“The flattening of the [yield] curves has been exacerbated by these flows,” said Stefano Di Domizio, head of fixed-income strategy at Absolute Strategy Research.
To be sure, all this hedging activity might have helped yields in the U.S. and Europe to fall more quickly to a level where they will eventually deserve to be. “It’s the middle of August, it’s quiet, so moves get exaggerated,” says Helen Anthony, a portfolio manager at Janus Henderson. “We were expecting this to play out over much longer than just this month.”
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