DE Shaw’s latest paper is a cautionary tale on the efficacy of short duration US Treasuries
Last month the fear of inflation in the US economy reared its head. Yields on 1-year US Treasury securities bounced higher from a low of 5.6 basis points on 19 February to 8.9 basis points by close of play on 25 February. For 2-year Treasuries, they went from 10.9 basis points to 16.8 basis points.
As CNBC reported, the 5-year breakeven rate, an indicator of the bond market’s expectations for inflation, rose to 2.38 per cent last month, which at the time was its highest level since pre-GFC.
At the time of writing, this has ticked up to 2.43 per cent.
Yesterday, Federal Reserve chairman Jay Powell signalled that the US central banks would remain “patient” in response to a temporary rise in inflation. With the US economy in continued growth mode, introducing a rate hike too soon, while the US tries to reduce its unemployment numbers, might derail GDP growth. But if inflation creeps up and yields continue to show upward movement over the next couple of quarters, a rise in real interest rates is highly likely. Indeed, the FTSE fell 1 per cent overnight as investors interpreted Powell’s comments as such.
Let’s face it, with US Treasury securities having fallen so sharply over the last 12 months in response to the pandemic, the risk to another negative market shock would leave bond investors with precious little capacity to hedge against equity risk. Any movement to the downside on bond prices will help push short-duration yields away from the lower bound of the federal funds rate of 0.25 per cent. A year ago, this was just over 1.5 per cent.
In many respects, this needs to happen in order to reintroduce some much needed capacity at the shorter end of the yield curve.
Well having just read an interesting white paper by the DE Shaw Group, modelling the performance of US Treasury securities over the last 12 months has shown that, while bonds did indeed behave as expected in March and April 2020, when the US economy tanked, it was a very different affair for the rest of the year.
The paper, entitled Running Low: The 2020 Test for Bonds as Hedging Assets, showed that between 14 February and 16 March, short-duration bonds (up to 5-year Treasuries) proved to be an effective equity hedge, with 2-year and 3-year Treasuries falling by 100 basis points on average.
Even 10-year Treasury securities did well, with actual yields falling 86 basis points compared to the 55 basis points in DE Shaw’s modeling predictions, which used a sample set spanning 1 January 2004 to 3t December 2019. The correlation of 10-year Treasury yields to the S&P 500 is still quite high.
But what DE Shaw’s research paper then goes on to show is just how limited US Treasury securities are, if there were to be another negative economic shock. Yields have fallen so much over the last year that unless one moves further out to 20- and 30-year bonds, one cannot hope to achieve any meaningful equity protection at the shorter end of the curve.
To briefly illustrate, if the US stock market experienced a similar sized sell-off to that seen last March, 3-year Treasury yields would fall 11 basis points, compared to 48 basis points predicted by the model. It is a similar story for 5- through to 10-year US Treasuries. Only when you move to the far end of the yield curve do yields begin to show meaningful protection: 41 basis points compared to 52 basis points for 30-Year Treasuries.
“One of the interesting results of the paper is that if the front end of the yield curve is constrained by the lower bound of the Fed funds target rate, then a viable solution is to move further out on the curve. Our results show that there is a favourable correlation as you move out to longer maturities,” comments Brian Sack, Director of Global Economics at the D. E. Shaw Group.
Much of the rubber has already hit the road in US bonds to expect investors to find any meaningful hedging benefits, which is why the recent bond market jitters in response to inflation is actually a positive development.
Sack is of the view that “longer duration treasuries are still able to respond to risk-off episodes and negative shocks in the way you would expect for a safe haven asset”.
Aside from 10- and 30-year US Treasuries demonstrating a high correlation to the S&P 500, which has been notable since 2012 (when they crossed to a higher correlation than 2-year Treasuries) another reason to explain why longer-duration bonds provide more hedging capabilities is linked to implied volatility. In the research paper, DE Shaw shows that while a sharp decline in implied volatility (i.e. less expectation that prices will move) was seen in 2-year Treasuries when Covid-19 struck, it hardly changed for 10- and 30-year securities.
So, the upshot to active managers is that in the current environment, unless inflation runs out of control and we see a significant rate hike, short-duration bonds offer precious little hedging capacity. The solution is to move further out on the yield curve.
Is this a long-term structural trend at the shorter end of the US yield curve?
Sack offers the following view: “I do think it is a new structural period in the sense that monetary policy is going to be constrained by the lower bound for meaningful periods of time.
“We’ve put out research in the past (Floor It: Market Pricing of the Lower Bound on Interest Rates) saying that such a constrained condition could exist at least 20 per cent of the time, and the Fed has published its own research suggesting it could be a third of the time. In those situations, we would expect the hedging benefits of short-duration Treasuries to be impaired.”
Views on inflationary risk will always polarise opinion and 2021 is no different in that respect. It is likely that inflation exceeds the Fed’s 2 per cent target, but it’s unlikely they would allow a substantial upward shift as they look to bring unemployment levels down closer to somewhere in the 3 per cent range; it was 6.3 per cent end of January this year. Real interest rates will have to move up, to prevent the US economy overheating.
Linking it back to DE Shaw’s research paper, Sack opines that if rates go higher, “then Treasuries will have more room to rally if there is another risk-off episode, supporting the safe haven status of those securities”.
Concerns over a substantial increase in long-term inflation expectations, or a steepening of the yield curve based on the supply of longer duration Treasuries, could potentially reduce the hedging capabilities at the longer end of the yield curve.
For now though, 10-year Treasuries offer plenty of capacity. Yields have risen to 159 basis points, compared to last July when they were at 60 basis points. As such, they still provide an effective hedge, were the US economy to be impacted over the near term.
If the US bond market remains constrained, and affect the hedging abilities of short and intermediate term Treasuries, it could begin to resemble two other major bond markets: namely Germany and Japan.
In that respect, DE Shaw’s research paper is a cautionary tale.
“Germany and Japan show us that the situation in the United States could become worse. If some of the secular trends towards lower neutral policy rates were to continue, you could be in a situation where the reduced hedging capacity becomes a more chronic condition across the entire yield curve.
“That’s not our expectation for the United States, but it is interesting that such a scenario has ready happened in other major global bond markets,” concludes Sack.