Why the rush to safe haven assets isn’t likely to last

What about natural disasters? The magnitude nine Japanese earthquake and subsequent tsunami that hit the Iwate Prefecture in 2011 led to widespread destruction and long-lasting disruption. Japanese
bonds rallied considerably (for Japanese bonds) over three days, before reversing entirely over the next week.

The outbreak of COVID-19, however, was far more exceptional.

The magnitude of the interruption – to completely understate it – was global and severe. The demand for US dollars soared, equities dropped about 30 per cent in the first 18 days of lockdowns. Bonds rallied as central banks slashed cash rates to zero and announced huge bond purchase programs, emphasising why they are a safe haven asset.

Financial conditions tighten with rising bond yields and ease if term bond yields fall. In contrast to Australia – where the variable mortgage rate regime gives far more potency to official cash rates – fixed rate regimes, such as the US, have financial conditions that are far more dictated by market forces.

Since late July, US Treasury markets have been absorbing the message from the Federal Reserve that cash rates were going to be held at elevated levels for an extended period of time. US 10-year bonds rose about 80 basis points, while peak cash rate expectations lifted only a little.

The evidence of tighter financial conditions is perhaps evidenced by a 7 per cent drop in US stocks over this time. Excluding the big stocks, the S&P 500 is down 10 per cent.

Further, the rally in long duration bonds after the strong US jobs data suggests that the recent leap in US yields has taken bonds to a level that the market assesses conditions as reasonably restrictive.

‘Things are likely to break’

So, the market thinks long bonds back towards 5 per cent moves the US closer to tight financial conditions. Should the safe haven bid to bonds pass, logically this is where we will be.

Given the recency to this move higher, the question is, what will happen when financial conditions remain tight? Things are more likely to break. Just when and where is difficult to pinpoint.

According to a recent article by MacroStrategy, US banks were sitting on losses in their bond portfolios at the end of Q1 of $US516 billion ($815 billion). As a guide, five-year Treasury yields were 3.5 per cent. They’re now about 4.60 per cent, so current estimates put that at closer to $US800 billion.

These bonds are not marked to market, but the event risk, should there be a forced sale caused by such things as deposits moving elsewhere, is definitionally increased with higher interest rates.

The fragmented US regional and community banking sectors are more
vulnerable to the stress; think Silicon Valley Bank. Moreover, whether marked to market or not, the banks’ balance sheets are incrementally impaired, causing a headwind to lending activity and money supply and, ultimately, economic activity.

The perversity of the safe haven bid – the 25 basis point drop in 10-year US
Treasuries – has been an easing of financial conditions. This perhaps explains why US stocks have rallied; not just oil stocks as one would expect in a Middle East conflict.

Many investors are now alert to the accrual being earned on high-grade bonds. What is perhaps less understood is the role of longer fixed-rate duration within a portfolio.

The benefits of yield, stability, and diversification afforded by fixed-rate duration via capital appreciation, has been evidenced by events of the past week. Less plainly in sights, but also present, has been the earlier tight financial conditions should there be a crack in part of the global banking sector, or the global economy slows more sharply.

For those waiting for a bell to ring, diversification and safe haven assets deal with things that come out of left field. The last week may be a shot across the bow.