Everyone hates duration

Good morning. A federal judge blocked Kroger’s bid to buy Albertsons. The case is not dead yet, but this definitely makes the outlook worse. The stocks of both grocers went down by only a little, showing just how few investors thought the merger would go through in the first place. Is anyone still betting on it? Email us: [email protected] and [email protected].

Duration

It’s outlook season, when Wall Street’s buy- and sellside strategists publish their expectations for 2025. The degree to which the strategists are confident in their own predictions is an interesting question. Outlook documents are sales tools, primarily designed to drum up business now rather than look clever in 12 months. All the same, they do give a flavour for the consensus mood on Wall Street. And right now the mood has two big components. First: stay long US growth equities. Second, and only slightly less universally, avoid the long end of the Treasury curve.

The pillars supporting the latter point are sensible enough. US budget deficits are bad and set to get worse. That long-dormant creature, the bond vigilante, has to wake up at some point. At the same time, the risk premium — the extra yield, over expected future short-term rates, that investors are paid for owning long Treasuries — is historically low. Finally, the inflation monster may not be dead, and Donald Trump’s policy proposals may feed it.

Here, for example, are Marc Seidner and Pramol Dhawan of the bond manager Pimco:

Predicting sudden market responses to long-term trends is difficult. There is no organised group of vigilantes poised to act at a specific debt threshold . . . [but] we are already making incremental adjustments in response to rising US deficits. Specifically, we’re less inclined to lend to the US government at the long end of the yield curve.

AllianceBernstein’s summary fits neatly on a spreadsheet: 

Structural risks; low-term premium, inflation volatility; diminishing diversification; prospect of excess issuance relative to demand for bonds.

The BlackRock Investment Institute puts it like this:

US outperformance is unlikely to extend to government bonds. We go tactically underweight long-term Treasuries as we expect investors to demand more compensation for the risk of holding them given persistent budget deficits, sticky inflation and greater bond market volatility.

And so on. This is all reasonable. With the 10- and 30-year bond offering yields that are nearly indistinguishable from the 4 per cent available on cash, you have to be very confident in rates coming down to move far out on the curve. And in the wake of the biggest inflationary incident in decades, and heading into a new administration that has sent mixed messages about policy, confidence is in short supply. On top of that, the recent poor performance of duration is hard to forget. If you ditched bonds for equities five years ago, you have no regrets:

JPMorgan Asset Management swims against the tide a bit, arguing there is room for the 10-year yield to drop alongside growth and inflation:

Since peaking at 5 per cent in mid-October, the 10-year has already fallen by 1 per cent, but we believe there is room for long-term rates to fall even further while [the] Fed remains on hold, particularly if growth and inflation continue to trend lower. This suggests that investors should consider stepping out of cash and extending duration as falling yields could generate strong price appreciation in longer maturity bonds.

“This suggests investors should consider” is not exactly a table-banging recommendation. But in the current environment, this is what a duration bull looks like.

Unhedged’s pal Edward Al-Hussainy of Columbia Threadneedle makes a more focused case for duration. He sees it as a way to protect those big equity gains. Rebalancing out of stocks and into duration is a bet that the yield on duration will outperform cash — that is, that rates will drift further down, or at least not rise outright. More importantly, though, it is a bet that if stocks should go down, bonds will go up. This is more likely to be true if inflation is low and stable.

Starting with yields of 4 per cent nominal and 2 per cent real, and assuming a high probability that inflation will not be like it was in 2022, and that stock-bond correlation will be negative, makes duration attractive right now.

I asked Al-Hussainy whether investors were warming up the idea. They are not. “Nobody likes duration,” he says. “It’s a hard conversation to have with clients who have made good money in not just stocks, but money markets and gold, too.”

China

On Monday, the Chinese Communist party’s politburo — its highest political body — announced it is changing its monetary policy guidance from “prudent” to “moderately loose”. Investors got excited. The Hang Seng index jumped 3 per cent and the Shenzhen and Shanghai CSI 300 index rose 1.3 per cent, momentarily reversing a choppy descent from the September rally:

There are reasons to believe this is a big deal. By some measures, monetary policy is too tight. According to Arthur Kroeber and his team at Gavekal Dragonomics, the real interest rate is slightly higher than the rate of GDP growth. As China is battling deflation and slow growth, that’s upside down:

Politburo announcements are also often the best insight into Xi Jinping’s thinking. If he is signalling more needs to be done on monetary policy, that suggests the long-awaited fiscal stimulus could meet investors’ high expectations at last. The same monetary policy stance has preceded stimulus in the past. The government adopted a “moderately loose” stance after the Great Financial Crisis, which was accompanied by Rmb4tn ($568bn at the time) of stimulus.

But, at the risk of beating a dead horse, this might be another case of much ado about nothing, particularly on the monetary policy front. The People’s Bank of China has lowered all three of its main policy rates this year. With deflation fears mounting, they have little choice but to go lower.

With low demand for credit and borrowing, the transmission of monetary policy into the economy is also relatively weak. And, at the end of the day, China’s problems are structural — not cyclical.

We’ll believe in meaningful Chinese stimulus when we see it.

(Reiter)

One good read

A great day in Harlem.

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