The S&P 500 has endured a tough performance run since Liberation Day on April 2nd, falling -5.4 percent. It was worse last week, down -12.0 percent (not including the intra-day lows), but recovered more than half of the losses.
Less well known but still covered in the financial press is that bonds are having a hard time, too. Since Liberation Day, the Bloomberg Aggregate bond index has fallen by -1.9 percent, but unlike the S&P 500, it didn’t get a reprieve last week.
In fact, at first, bonds responded precisely as you might open and expect them to, with yields falling and prices rising. That makes sense with a sharp equity sell-off, as investors sell their risky assets and buy safer ones. Prices only rose for two days after the big announcement, and then they started to fall.
Although most articles only refer to Treasuries falling, this applies to all areas of the bond market. Since Liberation Day, Treasuries are down -1.4 percent, mortgages are down -1.9 percent, and investment-grade corporate bonds are down -2.6 percent.
Those are the three major sectors of the investment-grade bond universe. Non-investment-grade corporate bonds, aka junk bonds, are down -2.7 percent. Corporate bonds should be down more since markets expect the economy to cool off, probably leading to defaults.
But why are safe-haven Treasury bonds down? Nobody knows for sure, but there are a couple of sensible reasons.
First, there are some technical issues at play. You may have read about a popular hedge fund trade known as the ‘basis trade,’ unwinding—the basis trade profits from the small price discrepancies between Treasuries, bond futures, and other derivatives.
Since the price discrepancies are small, investors need leverage for this trade; I’ve read that 100:1 isn’t uncommon. Sharp movements, even small ones, can force traders to unwind their positions quickly (and at tough prices) to meet margin calls. Large investors also report that liquidity is limited, which is exacerbating price changes.
A second, more nefarious, rationale behind the sell-off is foreign governments dumping their US bonds in retaliation for the tariffs. Trade deficits lead to capital surpluses, meaning that if we have a trade deficit with a country, they own an excess of our dollars that are likely invested in bonds.
If those countries, including China, want to fire an economic salvo at the US, one way to do it is to dump their Treasuries and dollars.
A third explanation is that bonds are pricing in higher inflation risk since higher tariffs generally mean higher prices. The Trump Administration argues that price hikes have a one-time effect and aren’t inflationary, but consumers are worried.
The most recent University of Michigan survey showed consumers think prices will be 6.7 percent higher in the coming year. Markets do not believe prices will rise that much, and consumers don’t have a good record of getting inflation right, but inflation can be self-reinforcing based on expectations.
However, an important market-based measure of inflation expectations, known as breakevens, has been down since Liberation Day across all major time frames, signaling that markets and consumers don’t see the current situation similarly.
As of Friday, the yield-to-worst on the Bloomberg US Aggregate was 4.9 percent. The yield-to-worst is a reasonably good estimate of future returns, so it’s worth watching. In the last 12 months, it’s been as low as 4.1 percent and as high as 5.3 percent.
For all the sturm und drang about the basis trade unwinding and the Chinese government’s possible liquidations, investors should ask themselves whether they’re okay with a nearly five percent return on their bond portfolio.
I trust market expectations for inflation more than consumers. The bond market expects inflation to be around 2.5 percent, meaning the ‘real’ return on bonds should be about two percent.
As with stocks, our strategy is to hold bonds through thick and thin. We adjust our portfolio based on various factors, and right now, the duration of our portfolios is shorter than the overall market, which translates into less volatility and downside risk.
Although bonds have had a hard week or two, this is unlike the 2022 experience, when stocks and bonds both fell more than ten percent. In that case, the Fed raised rates by five percentage points, and, importantly, the starting point was zero, meaning that there was no income cushion to offset the price losses.
I mentioned above what bonds have done since Liberation Day. It may be helpful to widen our view. So far this year, the Bloomberg Aggregate is up 1.1 percent through Friday.
That may not sound exciting, but we’re only a quarter through the year, so that’s about 3.9 percent in annualized terms. Of course, we might end up with a much different return by year-end, but annualizing the number helps put it in perspective.
Treasuries and mortgages are faring better, up 1.6 and 1.3 percent, respectively, equating to 6.0 and 4.6 percent in annualized terms. Corporate bonds aren’t faring as well as market prices in an economic slowdown, and they are down -0.1 percent for the fourth quarter or -0.2 percent in annualized terms.
As with stocks, we will keep monitoring the bond market closely and adjust as conditions warrant.
