Beware: the bond market is signalling troubles ahead

Beware: the bond market is signalling troubles ahead

Bonds
Althea Spinozzi

Senior Fixed Income Strategist

Summary:  It's time to turn cautious as the bond market is signalling a swift rise in interest rates amid strong inflationary pressures and more aggressive monetary policies. So far, risky assets have suffered due to a rise in interest rates. However, things can quickly turn for the wort as corporate spreads begin to widen as financial conditions tighten. As the Federal Reserve prepares to hike interest rates, we expect breakeven rates to drop and real yields to accelerate their rise, posing a threat to risky assets. Nominal yields will continue to rise, too, as they already point to much higher levels we have seen this year. Given the market volatility, we don't exclude seeing 10-year TIPS yields rising to 0.5% and 10-year nominal yields to 2% by the end of the year.


Investors should start to worry about their investments as there are signs of US Treasury yields moving higher, dragging with them lower-rated credits.

HYG, the iShares iBoxx High Yield Corporate Bond ETF, has broken a key support level at 86.5. Moving averages are all dropping in a sign that the ETF could further fall. Once the weak support line at 85.7 is broken, the ETF will likely continue its fall to 84.8. 

Source: Bloomberg and Saxo Group.
Don't jump to conclusions. The current drop in HYG and JNK (the SPDR Bloomberg High Yield Bond ETF) has been driven entirely by the recent rise in yields. Indeed, while the average yield to worst of US Corporate junk bonds has risen to 4.6%, the highest level since December 2020, their option-adjusted spread (OAS) remains around 300bps. That's in line with the level seen before the 2008 global financial crisis. It means that the JNK and HYG are falling due to a rise in interest rates and not because there are signs of distress in the weaker corporate bonds space. While with individual bonds, one can mitigate the risk of rising interest rates by holding the bond until maturity, it's impossible to do so with ETFs because there is no maturity date for these products. It highlights that amid an environment of high inflation and rising interest rates, it's essential to search for yields removing as much duration as possible. The junk bond market can provide for that, but it's critical to be prepared to hold those bonds until maturity.
Source: Bloomberg and Saxo Group.

The problem is that the higher US Treasury yields soar, the more pressure will be applied on weaker bonds, ultimately causing credit spreads to widen. At that point, it will be too late for risky assets as volatility will become endemic in both the bond and stock market.

One way to know when we might face a broad selloff is to monitor real yields. The faster they rise, the quicker financing conditions are tightening for the corporate space. Real yields remain well below zero. However, as the Federal Reserve prepares to tighten the economy, we can expect breakeven rates to fall and nominal yields to rise, accelerating the rise in real yields. That could provoke a deep selloff, not only within the junk bond space but also in stocks with high duration, such as tech stocks. That's is what happened amid the Taper Tantrum in 2013.

Source: Bloomberg and Saxo Group.

Therefore, it is vital to monitor the movements of both real and nominal yields. Below, we are going to highlight some critical levels.

Real yields

Ten-year TIPS have traded rangebound since August. However, if they break above their descending trendline, they will likely rise to test resistance at -0.70%. If interest rate hikes accelerate by the end of the year, we can expect real yields to rise to -0.50%. Partly, valuations will continue to be supported by negative real yields. Still, repricing will be inevitable due to the fast rise of real yields.

Source: Bloomberg and Saxo Group.

Nominal yields

Ten-year US Treasuries are trading in an uptrend. Yet, we expect them to remain in check until the debt ceiling crisis has been resolved, as they will serve as a safe haven amid volatility in money markets. At that point, they are likely to break above 1.75% and continue to rise to 2% amid inflationary pressures and more aggressive monetary policies.

Source: Bloomberg and Saxo Group.

Five-year yields are also trading in an uptrend towards 1.50%.

Source: Bloomberg and Saxo Group.

Two-year yields are likely to accelerate their rise as the market prices earlier interest rate hikes. Yields broke resistance at 0.55%, and they are now in a fast area which could take them quickly to 1%.

Source: Bloomberg and Saxo Group.

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