How to Trade the Bond Market’s “Rally-to-Rout” Whiplash

Shah Gilani|October 13, 2023

Just when I was all set to write about big bank earnings today, which were better than expected but not what you think, the reality of yesterday’s bond market action sank in, deeply, and was frankly frightening.

Besides, more important bank earnings reports from regional and smaller banks are coming.

The bad news for bonds yesterday was so pronounced that it not only reversed an audacious rally but also triggered the worst selloff in 10-year Treasuries since the Fed started hiking in March 2022.

What happened can realistically be called a buyer’s strike, or worse, a reality check on who’s not buying Treasuries anymore. And that’s beyond frightening.

Here’s what happened, as well as what it means for bonds, interest rates, stocks, the economy, and most importantly – how to trade it.

First of all, in case you didn’t notice, the bond market was in fast-track rally mode earlier this week, and I mean fast and furious.

After the 10-year Treasury yield got up to a cycle high of 4.81% on October 3, 2023, it collapsed. When yields fall, it means prices are rising. At the close on Friday, October 6, 2023, the 10-year yield dipped to 4.78%.

Then Hamas launched its assault on Israel on Saturday morning.

The bond market in the U.S. was closed on Monday, October 9th for a holiday, so on Tuesday, investors jumped into Treasuries and other “flight-to-safety,” “flight-to-quality” sovereign bills, notes, and bonds.

That headlong rush into Treasuries coincided with a percolating narrative, courtesy of dovish Fed-speak, that higher rates were doing the Fed’s job and further hiking might not be necessary. That motivated traders and investors to buy what were maybe the highest yields they were going to get, which drove short Treasury bettors to cover their suddenly wrong-way bets. All of this drove prices up so quickly that in only six trading days, by Wednesday, October 11th, the yield on the 10-year had collapsed to 4.58%.

That was a staggering 23 basis point rally in yields in six trading days.

The following day, Thursday, October 12th, the rally reversed, and the 10-year yield shot up by 12 basis points to 4.70%, in about a New York minute.

That was the worst day for bonds since the Fed started hiking in March 2022.

The preamble to the one-day bond rout story began earlier in the week when the reception to the Treasury’s auction of 3-year and 10-year notes was lukewarm at best. But when the Treasury auctioned $20 billion of 30-year bonds on Thursday, bidders puked.

Demand was so weak that dealers, who typically buy around 11% of an issue, had to step up and buy 18% of all those bonds. The yield jumped 12 basis points to 4.856% to get buyers to budge (as that 30-year auction faltered, the 10-year note price tumbled, resulting in its yield spiking from 4.58% to 4.70%).

The so-called auction “tail,” or the gap between the lowest bid price and the average, was the narrowest since November 2021, according to the Financial Times, “representing another sign of waning demand.”

More than a few realities hit home now.

Maybe yields are going higher without the Fed hiking because the interest alone on America’s outstanding debt costs more than $808 billion a year, and that’s before accounting for the higher cost of refinancing all the debt coming due that will cost a lot more to re-fi as rates have already risen by 500% in fed funds terms.

Maybe yields are going higher because, on top of refinancing, the country’s current budget deficit is more than $1.5 trillion and rising every year.

Maybe yields are rising because traditional buyers of Treasuries, such as the Chinese, Japanese, Saudis, and others, aren’t buying now.

Maybe yields are rising because the buyer of last resort, and then for years first resort, the Federal Reserve System, isn’t buying. They aren’t doing quantitative easing; in fact, they’re doing quantitative tightening – letting bills, notes, and bonds they own, $8 trillion worth, run off their fake balance sheet.

Those realities give new meaning to “higher for longer.” They mean much higher.

Maybe higher and higher, inflicting more losses on bond investors and insurance companies and pensions and banks and dealers already sitting on monumental losses on their inventories of lower-yielding fixed income assets on all their balance sheets.

Maybe so high that bond yields look much better to investors than stocks, which could result in a stock market selloff.

Much higher could mean a hard landing or a deep recession.

Welcome to the new “new normal” or “Abby Normal,” if you’re a fan of the 1974 Mel Brooks movie, Young Frankenstein.

With rates headed back up, maybe a lot higher than what we hoped would be high enough to tamp down inflation, investors have to make sure they have stops on their stock portfolios.

If rates go a lot higher and stocks sell off, investors can buy back in at lower levels, maybe much lower levels if we crash.

But there’s money to be made on the way down by shorting weak, faltering stocks. And money to be made in the bond market using inverse bond ETFs like ProShares UltraShort 20+ Year Treasury ETF (TBT) to bet on higher rates and iShares 20 Plus Year Treasury Bond ETF (TLT) to bet on bonds rallying when there are flight-to-quality rallies.

So, be careful out there. You’ve been warned.