We’d Rather Own Stocks, Even If Bonds Bounce Back

Treasuries just had their worst quarter since 1994, in terms of the 10Y yield rising. Ouch. That implies a sharp drop. What happened?

Unsurprisingly, it takes a village to have such a sharp move, so there were several causes. Energy prices spiked from the Iran war. The Fed hiked in September for the first time in three years, a sharp change from the beginning of the year, when cutting was considered more likely.

We also had the standard, long-lasting problems, such as the large deficit needing a lot of Treasury issuance and heavy AI spending. Long-term Treasuries started looking stressed and we saw some forced selling by leveraged buyers, along with shorts pressing that move. It’s also worth noting this is a worldwide event. There are plenty of countries that are more impacted by the rise in energy prices and are feeling even more pain.

So, what’s next? There tend to be limits to these sorts of moves. How many rate hikes are likely? How strong is growth and how likely is it to cause inflation? Those numbers are generally pointing down. Rate hike expectations peaked shortly before quarter-end, for example. That’s not very long ago, of course, so maybe they go back up, but we did see a decent decline after some soothing words from the Fed.

While some problems seem pretty intractable, such as government and AI borrowing demands, plenty of other factors look better. Inflation concerns rose in the last quarter but are well off the highs of April and May. Recent data is supportive of the idea there isn’t much wage pressure to push up inflation. The data, particularly lately, hasn’t been a strong argument for another rate hike.

Other issues seem short-term in nature. For instance, around quarter-end, there was a big scramble to get 10Y Treasuries, driving prices up (yields down) in the repo market. Traditionally, that tends to indicate there’s a lot of shorting going on. Additionally, the rapid rise in yields creates a feedback loop where rising yields force leveraged owners to sell, creating more pressure on bonds.

All that stress isn’t really fundamental. It’s shorts chasing stressed, levered longs. That’s a game with an expiration date. When rates stop moving up so sharply, that game should end. We’ve already seen rates start to relax, particularly on the short end. It may be somewhat aggressive, but it’s reasonable to think rate stress is closer to the end, rather than ready to launch another round.

What I’d look at is if we make new highs in yields. Even the long-end peaked Thursday morning, despite continued selling on Friday following the gap-up after the payrolls report. If we can continue to fail to hit new highs in yields, levered-long stress will lessen, and shorts will have less power. For this week, I’ll be staring hard at yields, particularly on the long end. This is a particularly big week, as we have monthly coupon refunding, so there are a lot of bond auctions, particularly a 10Y auction on Wednesday and a 30Y auction on Thursday.

Bonds have certainly been the worst for quite a while, now. Honestly, with the economy still going strong, I’d rather own stocks, even if bonds bounce back. That said, if rate expectations are setting a top, here, then upside can look a lot better. Recently stressed areas, like financials, mortgage REITs, and housing should look a lot better. Bonds, of course, can also look much better, given high real rates offer fundamentally more attractive future returns than we’ve seen for a long time.

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