Bonds Rally.. Finally.

Last week seemed confusing, with hot inflation prints but bonds getting a bid anyway. How did bonds end up doing well despite strong inflation and decent economic data? I don’t think there’s a totally clear answer, which is too bad, because it would be good to know exactly what happened. Let’s go over a few possibilities.

First, there’s the thought of reversion. Bonds were heavily oversold, the worst since 2023. It wasn’t going to take a lot to improve that, as oversold readings imply positioning was heavily slanted. Indeed, I’ve reported on signs around the end of the quarter that bond shorts were having a hard time keeping their positions in place.

Those are classic conditions for a squeeze, where it takes very little for the asset to move the other way. Indeed, some event traders can create a “buy the news” reaction, where they are positioned for an event and cover that short once the catalyst passes. In this case, it was known that CPI and PPI were likely to be hot. Potentially, investors could have been short, then covered once the event was over, even though the data went their way. This can also create reflexivity, where event-traders buy back shorts, then trend followers buy a change in trend.

Second, there has long been an idea that breaking the AI trade would cause a bid in bonds. Arguably, we’ve seen that. While the numbers still look good, there have been some who are worried about things like Anthropic growth and datacenter financing costs. We have also seen a tiny AI company (Character.ai) declare bankruptcy. Why would the AI trade breaking cause a bond bid?

There are two reasons AI slowing would make bonds go up. First, AI spending is what’s driving economic growth. If economic growth is slowing, growth and inflation should slow, making stocks less attractive and bonds more attractive. Indeed, yields peaked when the Atlanta Fed’s GDPNow peaked. Second, if AI growth slows, demand for financing should slow, which means less competition for bond dollars. We saw noise out of banks last week that they were slowing corporate loan growth from AI or demanding more collateral.

Third, bonds are a much better deal now than when yields were lower. Real yields peaked at 2.95% on the 10Y and 3.37% on October 5th. That’s a pretty good option for getting a secure return. You could lock that in plus inflation for a long time, making things like long-term TIPS (Treasury Inflation Protected Securities, pictured below) look pretty interesting. If you’re trying to fund a long-term liability, that could work well.

Of course, the big question is always where do we go from here? That’s also always a tough question, as the market works hard to price in knowns, so the current price is reasonably fair. The question from there is what of the above really caused bonds to bid, last week?

If it’s due to AI growth actually slowing, then the bottom is in for bonds, and they should do very well from here. Unfortunately, there’s very little concrete data pointing to the idea that AI growth is materially slowing. That doesn’t mean bonds have to keep going down, though. We’ve already seen an extreme move that got flushed out, which often marks a bottom.

I think it’s reasonable to believe that bond yields have largely peaked but bonds don’t get a strong bid for a while. My reasoning is that AI still appears to be going fine, something we should see in coming earnings reports, but yields largely priced that in. The current expectations in terms of what the Fed will do and what AI growth will do has probably peaked, at least for a while.

That was our thinking on our recent buy of Annaly Mortgage (NLY.) Bond stress stood a good chance of being around a peak. We waited until it looked like bonds were no longer trending higher and bought on Tuesday. We don’t necessarily think Annaly will take off immediately from here, but they could if the AI trade is in worse shape than I think. In the meantime, we got a yield over 16% that should be pretty secure while we wait.

Industrial Production was 0.7% m/m vs. exp. 0.4%. That’s the highest Y/Y growth since 2022, at 2.25%. Capacity Utilization was 76.85%, the highest since 2023. Pretty good.

Import Prices were up 1.1% m/m vs. exp. 0.8%, but Export Prices were even higher, at 2.2% vs. exp. 1%. Those high import prices are going to nudge inflation numbers higher, though.

CNN’s Fear & Greed index fell to 18, the lowest since April.

Big VIX (volatility) spike on Friday, from 16 to 20, as the market dropped a percent, with high beta dropping more. We’re down to the 18s this morning.

After dropping over 3% on Friday, semiconductors (SMH) are bouncing back over 2% this morning. Why the drop and pop? I don’t know, but Friday was options expiration (OpEx) and the move does seem related to positioning. VIX expiration is on Wednesday, which could cause more moves, considering heavy buying in the space.

Steel company Cleveland Cliffs (CLF) is up 11% after beating on earnings but missing on revenue.

Bottom Line: Semis are bouncing back following a harsh OpEx. Did we flush out positioning or is there more excitement coming with Wednesday’s VIXpiration?

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