Interest Rates’ Spike and a Lesson in Markets’ Efficiency

Stop us if you have heard this one before: Long-term interest rates’ recent jump is only the beginning, setting up good times for value stocks and bad times for fixed income investors. Stock investors are salivating at the prospect of cyclical categories like Financials racing ahead, and as several articles noted Monday, short positions in US Treasurys are at record levels. In our view, it all seems very characteristic of short-term moves—the kind destined to fade fast.

Because of bonds’ safe haven reputation, it is easy for many to forget that bonds, like stocks, are volatile. They have less expected short-term volatility than stocks, but they still wiggle plenty and are prone to sharp sentiment-driven pullbacks. We think this is what bonds are experiencing today, rather than a lasting move.

Sentiment toward bonds right now reminds us an awful lot of sentiment toward stocks during a typical correction. In stocks, we would define that as an emotion-driven move of around -10% to -20%. Stock corrections can start for any or even no apparent reason, and they usually begin and end without warning. Sentiment plunges quickly, prompting investors to make knee-jerk reactions in hopes of avoiding worse pain to come. For some, that means ditching stocks. For others, that means rapidly adding short positions. Either would qualify as evidence of capitulation—abandoning hope of a near-term recovery and incorporating the reigning fears into portfolio decisions. Corrections usually end as this process reaches fever pitch and all the negativity gets priced in, setting the stage for a fast rebound that catches people flat footed.

Correction definitions in bond markets are less cut and dry, so most pundits couch sharp moves like the present with squishy, undefined terms like “tantrum.” But lingo and technicalities aside, bond market tantrums frequently happen because of sentiment, not fundamental change. They also tend to come and go quickly, as 2013’s so-called tantrum did. Then, 10-year US Treasury yields jumped from 1.66% on May 1 to 3.04% at yearend as investors anticipated the “tapering” and eventual end of the Fed’s quantitative easing (QE) bond purchases.^[i] Most investors were sure a longer rise was in store as tapering actually got underway in 2014. But yields fell instead—taper terror was priced after seven months of constant chatter. By the end of January 2015, 10-year yields were back near pre-taper terror levels. Other wiggles over the past decade faded similarly quickly.

That fading often happens when the perceived negative is fully baked into prices. In our view, the cocktail of abundant chatter and record shorting of US Treasurys is a strong tell—it means people are putting mountains of money behind a fearful narrative. Therefore, to argue bonds have a long ugly stretch looming from here is to argue that either everyone is still overlooking something even more troublesome than what we see splashed across headlines, or that markets aren’t at all efficient. In our experience, the latter is never a wise assertion. Nor is high short interest a self-fulfilling prophecy, as this year’s GameStop theatrics show.^[ii] Short sellers are often wrong. Not that we are making a short-term forecast, mind you—the tantrum could turn tomorrow, next week, next month or later. Sharp moves are impossible to predict and time with precision. That is why we suggest not trying and, instead, thinking longer-term.

While sentiment can swing bonds in the short term, they move on supply and demand in the longer term—just like stocks. In our view, supply and demand drivers didn’t suddenly change last month. Deficits and bond issuance plans are widely known. Most planned US issuance is at the shorter end of the yield curve, making supply rather scarce at the long end—a recipe for tame yields in the mid to longer term. Pension funds and other institutional investors still fuel high demand, in accordance with their long-term needs and mandates. US Treasurys are also among the highest-yielding in the developed world, keeping them in high demand globally.

Inflation expectations are a chief ingredient in long-term interest rate moves. Today, inflation chatter abounds, but the ingredients for significantly higher inflation aren’t present at the moment. Yes, money supply soared last year as the Fed relaunched QE. But velocity is super low, effectively sterilizing the uptick. That could change, but there is no real sign of it today. Now, as we wrote last week, inflation rates likely will pick up this spring and summer. But that is more about the depressed base from last year than trends in 2021, as prices fell during the lockdown-induced economic contraction. That is also well-known—so well-known Fed head Jerome Powell even cited it. Markets generally see through stuff like that.

Therefore, if you are pinning hopes for value stocks on interest rates rising from here and staying there, we think you likely risk making a textbook error—trading on a widely known investment thesis. If everyone and their mother is calling for rising rates to send value stocks to the moon, that is probably a good sign that the market is about to upend popular expectations. If massively popular trades like this always worked out in their proponents’ favor, investing would be the easiest thing in the world and everyone would be good at it. But that just isn’t how markets work, and in our view, the wisest move today is to look where everyone isn’t: at the likelihood of interest rates reversing from here and undercutting the thesis to buy value stalwarts reliant on higher rates, like banks.