The world of the $24 trillion Treasury suddenly looks less dangerous

(Bloomberg) — A historic selloff in bonds has wreaked havoc on global markets all year, while fueling a crisis of confidence in everything from the 60-40 portfolio complex to the world of big tech investments.

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Now headed for a possible economic downturn, the nearly $24 trillion Treasury bond market suddenly looks less dangerous.

The latest U.S. consumer price data suggested inflation may finally be cooling, pushing investors back into the asset class en masse on Thursday as traders trimmed bets on Federal Reserve hawks. Another reason this once-safe haven looks safer than it has in a while: Even rising interest rates have less power to crush bond portfolios than they have in the past two years.

Just look at duration, which measures the sensitivity of bond prices to changes in yields. It’s a tried-and-tested measure of risk and reward that guides all flavors of fixed-income investing — and it’s fallen sharply this year.

With the Fed’s aggressive policy-tightening campaign this year pushing Treasury yields to near-decade highs, the margin of safety for anyone buying U.S. debt right now has improved significantly compared to the low-interest-rate, pre-bull market era to collapse as a result of pandemic inflation.

Thanks to higher yields and coupon payments, simple bond math shows that duration risk is lower, meaning another selloff from here would cause less pain for money managers. That’s a favorable outlook after two years of crushing losses on a scale largely unseen in the modern era of Wall Street.

“Bonds are becoming a little less risky,” said Christian Müller-Glissmann, head of asset allocation strategy at Goldman Sachs Group Inc., who shifted from underweight to neutral in bonds in late September. “The overall volatility of bonds is probably going to go down because you don’t have the same duration, and that’s healthy. Net-net, bonds become more investable.”

Consider the two-year Treasury. Its yield would need to rise a whopping 233 basis points before holders actually suffer a total return loss next year, thanks mainly to the cushion provided by strong interest payments, according to an analysis by Bloomberg Intelligence strategist Ira Jersey.

At higher yields, the amount the investor is compensated for each unit of duration risk has risen. And that has raised the bar before further increases in yields create a capital loss. Higher coupon payments and shorter maturities can also serve to reduce interest rate risk.

“The simple math of bonds to increase yield reduces duration,” said Dave Plecha, global head of fixed income at Dimensional Fund Advisors.

And take the Sherman ratio, an alternative measure of interest rate risk named after DoubleLine Capital’s deputy chief investment officer Jeffrey Sherman. In the Bloomberg USAgg index, it has increased from 0.25 a year ago to 0.76 today. That means it would take a 76 basis point increase in interest rates in one year to offset the yield on a bond. A year ago, that would have taken just 25 basis points — the equivalent of one normal-sized Fed hike.

Overall, a key measure of duration on Bloomberg’s U.S. Treasury index, which tracks roughly $10 trillion, fell from a record 7.4 to 6.1. That’s the least since around 2019. While a 50 basis point rise in yields resulted in a loss of more than $350 billion at the end of last year, today the same hit is a more modest $300 billion.

It’s far from clear cut, but it reduces downside risk for those returning to Treasuries attracted by income — and the prospect that lower inflation or slower growth will push bond prices higher in the future.

Read more: High-end durations have steepest decline since Volcker’s rise

After all, the cooling of US consumer prices for October offers hope that the biggest inflation shock in decades is abating, which would be a welcome prospect for the US central bank when it meets next month to deliver a likely hike from 50 basis points of the reference interest rates.

The yield on two-year government bonds rose this month to 4.8% – the most since 2007 – but fell 25 basis points on Thursday in the CPI report. The yield on the 10-year note, now hovering around 3.81%, down from 1.51% at the end of 2021, also fell 35 basis points in the past week, which was shortened by the Veterans Day holiday in Friday.

The counterpoint is that buying bonds is far from a hassle-free trade given the continued uncertainty about the trajectory of inflation as the Fed threatens further aggressive rate hikes. But the math suggests that investors are now slightly better compensated for risks across the curve. This, along with a darkening economic environment, is giving some managers the confidence to slowly recover their exposures from multi-year lows.

“We cover the underweights of duration,” said Ian Steely, CIO of fixed income at JPMorgan Asset Management. “I don’t think we’re completely out of the woods yet, but we’re definitely closer to peak yields.” We are significantly less underweight than we were.”

And of course, the recent rally suggests that an asset class that has fallen sharply out of favor over the past two years is finally turning around.

The defining narrative for 2023 will be a “deteriorating labor market, low-growth environment and moderate wages,” BMO strategist Benjamin Jeffrey said on the firm’s Macro Horizons podcast. “All of this will reinforce that cheap money buying that we argue has started to materialize over the last few weeks.”

What to watch

  • Economic calendar:

    • November 15: Imperial Production; PPIs; Bloomberg November US Economic Survey

    • November 16: MBA mortgage applications; retail sales; index of import and export prices; industrial production; business stocks; NAHB housing index; TIC is flowing

    • November 17: Start of housing construction/permitting; Philadelphia Fed Business Outlook; weekly unemployment claims; Kansas City Fed Production

    • November 18: Existing Home Sales; leading index

  • Fed Calendar:

    • November 14; Fed Vice Chairman Lael Brainard; New York Federal Reserve President John Williams

    • November 15: Philadelphia Federal Reserve President Patrick Harker; Fed Governor Lisa Cook; Michael Barr, Federal Reserve Vice Chairman for Supervision

    • November 16; Williams Delivers Keynotes at 2022 US Treasury Markets Conference; Bar; Fed Governor Christopher Waller;

    • November 17: St. Louis Fed President James Bullard; Fed Governor Michelle Bowman; Cleveland Federal Reserve President Loretta Mester; Fed Governor Philip Jefferson; Minneapolis Federal Reserve President Neil Kashkari

  • Auction calendar:

    • November 14: bills for weeks 13 and 26

    • November 16: 17-week accounts; 20-year bonds

    • November 17: 4- and 8-week bills; 10-year TIPS Reopening

–With help from Sebastian Boyd and Brian Chapata.

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