Via Damien Boey at Credit Suisse:
Overnight, US 10-year bond yields surged by another 9bps. Over the past 5 days, bond yields have risen by almost 30bps. Catalysts for the bond sell off include reports of German fiscal stimulus in the pipeline, and a more conciliatory tone to US-China trade negotiations. We cannot also help but feel that positive economic data surprises are contributing to the bearish mood for bonds as well.
Within the equity market, momentum factor performance has been absolutely crushed over the same period, generating -12% returns on a sector-neutral basis. Sector-neutral momentum factor performance is now negative for the year-to-date. On the flipside, value factor performance has surged, returning almost 9% over the past 5 days. To be sure, value factor performance remains negative year-to-date – but the sector-neutral long-short index is now at its highest level since mid-May, when our proprietary timing signals really started to favour the factor.
There is a danger in correlating factors too heavily with bond yield movements. History tells us that on average, quality factors do well when bond yields fall. But the value story is more nuanced. Value tends to do well when the slope of the yield curve steepens, as opposed to 10-year bond yields rising. Also, momentum is not always correlated with quality, like it has been recently. It is only because momentum and quality rank correlations have become so high, that recently, momentum has underperformed as bond yields have risen.
One of the most interesting things to note from the past week is the delta of each factor’s performance to bond yield movements. US 10-year bond yields are only back at levels seen since early August. But the momentum sector-neutral long-short index is now well below August levels, while the value sector-neutral long-short index is well above. The deltas of momentum and value factor performance to bond yield movements has been very large. This is indicative of extremely crowded positioning, and a rush to the exits on even small bond yield movements.
Another interesting thing to note is that bonds are still priced for extremely negative short-term returns. In our recent note “Tail risk or apocalypse” dated 5 September 2009, we argued that a combination of term risk premia, and bond fair value models was pointing to year-ahead returns on US 10-year bonds of -6%. Considering that the most liquid US 10-year Treasury bond at the time was yielding 1.625%, this outlook for total returns was consistent with capital losses of almost 8%. And considering the average duration of a 10-year bond of around 7-8, this implies a 100bps+ rise in yields. So far, bond yields have risen 30bps. But our models, on a mark-to-market basis, are still pointing to another 100bps+ rise in yields (ie potentially 130bps in total). We mention all of this, not so much to come up with a point estimate for where bond yields need to go, but merely to illustrate that the sell off still has room to go.
Similarly, there is still longevity in curve steepening trades. From an equity market perspective, the rotation out of momentum and quality, into value, still has some way to go.
Is still think is a counter-trend rally but am sure glad that we’re not long Momo. Nor do I think Momo will rebound when the rally rolls, given it will being do so into virtual global recession.