馃巸馃 DEBT MARKET: NIGHTMARE ON BOND STREET 馃馃巸
The debt market is bleeding.... The aggressive increase in interest rates has driven bond prices down. However, there is another factor: time. Any bond is going to be more sensitive to interest rates if its maturity is >20 years, versus others <10 years, for example. The longer the maturity, the more complicated it is to collect the initial capital. This effect is known as "convexity", and it applies to any debt instrument. Thus, the debt market can be understood according to two main rules:
- Yield rates > price of bonds
- Long term maturity (sensitivity) > Short term maturity (sensitivity)
On the table are relevant cards: China has been reducing its US bonds for 5 years now, fears of another 70-80 era with high inflation, loss of US power, global geopolitical tensions and desires for a new order. This has exacerbated expectations about interest rates and the payment capacity of these securities over time.
This seems alien to anyone, but it is not. The debt market is the second largest market after FOREX, ahead of equities, derivatives and commodities. Many retirement funds are linked to it. In addition, bonds are the way in which a state can finance itself, and any damage to them can have an international economic impact. In other words, every country in the Western world is governed by this dynamic, where country risk is another additional element in the expectations equation.
Interest rate hikes are now expected. However, this could be obvious and very predictable. There will be a big crisis, but it is too early now. Nations do not have that luxury now and in fact, in government and the military, the best attacks come when no one expects them.
In this regard, here is an example of scenarios in which the price of the long-term >20-year bond ETF could fluctuate, as a proxy for the behavior of all long-term market debt in the Western world. It is difficult to make a forecast, but some level might be relevant:
Scenario <5 years:
- Call [sell]: ≈ $115
- Call [buy]: ≈ $94.8
- Put [buy]: ≈ $83.20
- Put [sell]: ≈ $81.3
Scenario >10 years:
- Call [sell]: ≈ $134
- Put [buy]: ≈ $101
- Put [sell/buy]: ≈ $66
Surely the above scenario will not occur exactly. It is only intended to reflect the general trend, which is bearish in price and bullish in yield rates. What is very unlikely is to see rates close to 0 again for a long time, with inflation below 2% If you are interested in knowing about inflationary episodes, you should visit: https://www.whitehouse.gov/cea/written-materials/2021/07/06/historical-parallels-to-todays-inflationary-episode/ .
What do you think might happen?
The best analysis is yours!
J. Joel Padilla
Copyright: Joel Padilla 2023
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