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November saw a major turn in bond market direction. Investors who have spent the past three years watching yields march higher and bond prices drift lower are understandably cautious to chase the newly positive tape. Unlike some of the past head-fakes, however, this change in trend seems well supported by both fundamental and technical factors. So, yes, Virginia, the bond market is investible again.
The difference this time, we believe, is really in the quality of the investing setup. As we have established in prior notes, a great rally setup includes four key elements:
Toss in a catalyst and you are off to the races. For the bond market looking into 2024, all of these appear to be in place. Count us amongst the rally’s believers.
The most important element of an investing setup is an extremely low price. One can argue whether current bond market prices are extreme from a long-historic sense, but within the context of the past 15 years, the recent lows represent rock bottom pricing. There simply hasn’t been a market outside of a few days in March 2020 when most high-grade bonds yielded more than 6% and any longer-dated government notes priced below $0.50 on the dollar.
Monetary policy works with a long and variable lag. After a year and a half of one of the most aggressive hiking cycles in recent history, some visible cracks have begun to appear in the edifice of economic strength. Consumer confidence, business investment, and a variety of other indicators have begun flashing signs that only appear around the onset of recessions. With the slowing outlook, inflation has been moderating.
Were a proper recession to arrive, one would expect inflation to cool even further, and that development would provide the key fundamental ingredient required for a sustainable rally in bonds.
The best rallies start from a point of extreme negative sentiment. And, with respect to the bond market, it is worth noting that late October 2023 showed maximum bearish sentiment readings for U.S. Treasuries.1 As the late, great Richard Russell used to remind us, markets make opinions, as opposed to the other way around. After more than three years of a progressively weakening tape, investors weren’t just indifferent to T-bonds, they hated them. What great psychic fuel for a meaningful rally!
As with sentiment, extreme positioning often speaks to the magnitude of a potential rally. Again, we see an interesting signal in the Treasuries market. On November 21, the Commodity Futures Trading Commission reported a net short position in the five-year U.S. Treasury of approximately $1.5 million contracts. That total represented the biggest five-year net short position in history, almost doubling the peak net-short of the 2018 cycle high.
We believe long-only asset allocators everywhere are overweight cash-like assets while hedge funds have been pressing bond shorts to extremes. The combined power of unwinding hedge trades with the re-entry into the bond market of GIC-type investors may give the recent reversal the legs needed to establish a full-fledged bond bull market.
Geoff Castle is Lead Portfolio Manager of PenderFund Capital Management’s Fixed Income Portfolios, including the Pender Corporate Bond Fund. Excerpted from the Pender Fixed Income Manager’s Commentary, November 2023. Used with permission.
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