(Bloomberg) -- A wild year on Wall Street has traders fretting one of two extreme scenarios will engulf the $23 trillion Treasury market ahead: Either a fresh bond selloff thanks to red-hot inflation -- or a sustained rally on mounting recession risk that sends yields back toward historic lows.
Market participants are butting heads over what big move will come next.
The Federal Reserve is embarking on a high-wire mission to ramp up interest rates at the fastest pace in decades without crashing the real economy, endangering investing styles of all stripes.
In a bearish scenario, managers like Bridgewater Associates reckon the 10-year yield could jump to 4% as inflation proves relentless -- a prospect that risks more damage for just about everything from tech stocks to emerging markets.
On the bullish flip side, an economic “hurricane” talked up by JPMorgan Chase & Co. Chief Executive Jamie Dimon could see yields falling back around 2.25%, according to a less-popular but no less-volatile scenario advanced by the likes of Standard Chartered Plc.
It all threatens to add a fresh twist for Treasury investors, who are already grappling with haywire moves and near double-digit losses with few precedents in the modern trading era.
Corporate America and its investors are mired in economic uncertainty as inflation stays near four-decade highs while signs emerge of consumer weakness and lockdowns in China add to risk of global stagflation. JPMorgan’s Dimon told clients last week to prep for tougher economic times -- a warning echoed by Goldman Sachs Group Inc.’s John Waldron but downplayed by many including Bank of America Corp.’s Brian Moynihan.
“It’s a very bimodal world now,” says Vineer Bhansali, the founder of LongTail Alpha LLC. “It’s either an inflationary outcome where yields keep going up, or a deflationary outcome where yields go down.”
In statistical parlance, the tails are getting fatter, meaning the probability of extreme events in either direction is at the risk of rising. While asset managers have built up net longs in 10-year futures to the highest in about two years, leveraged funds are short, according to Commodity Futures Trading Commission data.
Bhansali for one, reckons behind-the-curve monetary officials will overshoot with interest-rate hikes -- spurring short-dated yields higher initially and ultimately killing off the economic expansion eventually.
The Newport Beach, California-based asset manager, which netted a 929% gain in the pandemic stock crash, is buying up policy-sensitive two-year Treasury securities. Last year Bhansali had a big bond short launched in the grip of the inflation chaos.
“Given so much political pressure on the Fed, they are tightening -- and are going to over-tighten,” says the executive at LongTail, which deploys leverage and options to make big market calls. “There’s a slow-motion train wreck going on.”
These kind of growth-related fears whipsawed the Treasury market in May -- the first month of positive returns since November 2021, with 10-year yields tumbling to as low as 2.7% from as high as 3.2%. This month, the benchmark is trading in a narrower range around the 3% mark.
To Rebecca Patterson at Bridgewater Associates, the great 2022 bond selloff is far from over as all signs still suggest inflation will prove relentless.
“Given our views on inflation and Fed tightening needs, we see it as possible that the 10-year Treasury yield rises further -- and we don’t rule out yields at 4% or even higher,” says Patterson, the chief investment strategist at the world’s largest hedge fund.
Monetary officials are expected to deliver two half-point hikes at the June and July meetings, with traders pricing in more than an 80% chance of a third increase in September. All this is starting to work its way through the economy by denting consumer spending and sending the pandemic-era housing boom back to Earth.
Read more: Treasuries Tread Uncertain Path Amid Fed’s Bond Runoff Plan (3)
Leo Grohowski, for one, sees a disruptive tightening in financial conditions in the making that will create growth problems ahead, even as Fed officials seek to quash talk of a September pause.
“The potential for a policy error has begun to rise,” says the chief investment officer for BNY Mellon Wealth Management, who expects the 10-year security will close out the year at around 2.5%. “There is a risk the Fed is too hawkish and keeps tightening into a slowing economy.”
U-Turn
The Fed has U-turned before. In 2019, it loosened monetary policy after the damage inflicted on financial markets when it increased interest rates and shifted its balance-sheet holdings the previous year. In 2011, the 10-year yield closed the year below 2%, after peaking at around 3.75% in February as a slowdown in growth and the threat of a government shutdown suddenly boosted havens.
This time, unprecedented supply-side pressures are colliding with the economic aftermath of a pandemic, creating a fresh policy headache for Fed Chair Jerome Powell and his colleagues.
Perhaps the simplest trade is to follow the trend. Betting against bonds was key to AlphaSimplex Group netting a 33.5% gain this year in its mutual fund. And the firm’s statistical models suggest the momentum trade still has juice.
“If inflation numbers keep coming out like they are, they will have to keep fighting,” says Kathryn Kaminski, a portfolio manager at AlphaSimplex, referring to Fed officials. “The short-bonds trade still has some legs to go.”
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