JPMorgan's Jay Barry on the Big Selloff in Bonds

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1:16Hello and welcome to another episode of the Oddbots podcast. I'm Tracy Alloway. And I'm Joe Weisenthal. So Joe, the big story in markets up until relatively recently has been the bond sell-off, like quite a dramatic sell-off across the fixed income space. Yeah, really over like, I guess, is the last couple months. So the yield today, well, we can sort of talk about the bond market up until today. But, you know, we had been like in the threes and the fours. And then we got almost as high as 4.9 % on the 10-year. We've had a little bit of a pullback. We're recording this October 10th. But we are very high by any recent standards.

1:54Yeah, it is not lost on me that we are recording our bond sell-off episode on the day when treasuries are recording their best one-day performance since, I think, March of last year. But, you know, we're trying. We're trying here. But you're right. The recent bond market sell-off, it was one of those times when you see a lot of superlatives around a lot of, like, highest yields since 2007, a lot of talk of standard deviation moves. when we try to start calculating how many normal trading days it would take to get moves of this size. But the interesting thing about this whole dynamic is it's not really clear what the proximate cause of the sell-off is.

2:34So you have a lot of people blaming the recent FOMC meeting when they released the dot plot showing higher for longer. You have some people blaming oil. You have people talking about supply. Some people are looking at more technical aspects. You have some people blaming the term premium, which I find absolutely hilarious because to me, a higher term premium is like a symptom of the sell-off, not the actual driver of it. But anyway, all of this means we really need to try to get into the weeds of what is happening here and what it might mean for the wider market. Right. Because even if, okay, maybe last Friday, right after the jobs report, when we got that very brief spike.

3:14Maybe that was the peak. Who knows? But I do think it's important to try to disambiguate these things because, as you said, I guess it's one of those things when there's a lot of explanations for something, none of them are very satisfying. A lot of deficit talk lately. But it's like, what? I think we knew that the deficit was really big for a long time. There was that recent Fed meeting. But again, OK, the 2024 dots came up a little bit, But does that really explain 4.9 % on the 10-year? Nothing is quite satisfying as to what happened and why we're at this sort of like new level. Exactly. Well put.

3:49So today, I am very pleased to say we do, in fact, have the perfect guest. We're going to be speaking to a bond analyst. I've been a fan of his research for a long time. He used to work with one of our other favorite All Thoughts guests, Josh Younger. We're going to be speaking with Jay Barry. He is the co-head of U.S. interest rate strategy at J.P. Morgan. We're going to be trying to get a handle on what might be driving the moves in bonds, but also how you go about, as an analyst, trying to disaggregate all these different factors. So I'm very excited. Jay, thank you so much for coming on All Thoughts.

4:22Tracy, thanks so much for having me. Really appreciate being here. So I guess maybe just to begin with, I mean, the simple question, what is driving the sell-off? We'll start there and then we can try to dig into different pieces. Well, I mean, Joe just said there's a whole host of reasons that have been bantered about and that maybe none of them are all satisfying. But I really think it's the confluence of a number of different factors here. So, I mean, in aggregate, now we're off the highs in yield, as you said, but we're still about 100 basis points higher than we were in the middle of the summer.

4:50And to me, it's like what's changed over that period? And I think the early part of the move, you could say, was definitively a story about the U.S. economy and fundamentals. Because I look back at where we were very early in the summer and where we are right now. And over that period, we increased our second half growth expectations at J.P. Morgan by about two and a half percentage points from like the mildest of recessions, if you can call it that, to looking for above trend growth the second half of this year. and that's like a meaningful driver, I think, of the move in long-term rates because it's given us more confidence that the recession may be a bit further off, but it's also helped sort of anchor Fed expectations at higher levels as well.

5:26So, you know, we haven't really changed the expected peak in the Fed funds rate since the early part of the summer, but we pushed out the timing and we pushed it out from, you know, at that time thinking it was going to happen around now to sort of pushing it out to the early part of next year. But then the more powerful influence is that we've disinverted that money market curve a bit. And that early in the summer, we were pricing about 150 basis points of cuts for 2024. Now we're pricing in still cuts, but we've taken out about 40 % of that. So I think the first part was fundamental, but then I think the drivers began to shift.

5:58And more recently since September, Fed and growth expectations have been pretty stable, but inflation expectations have been rising. And we like to look at five-year ahead, five-year inflation expectations from the tips market from the inflation-linked treasury market. And those break-even expectations have gone higher by about 25 basis points over the past six weeks. Wait, this is the five-year, five-year forward break-even? Is that the thing that you like to look at? I'll bring that up on my terminal while you're talking about it. So I understand, okay, growth has picked up versus expectations, certainly compared to the beginning of the year when, as you say, almost everyone expected the recession.

6:35Now we're at above trend growth. Maybe it'll moderate, et cetera. What is the link between that and 30-year yields or the long end of the curve? Because of course I get it. The short end, it's very easy to draw a very bright line between short-term rate expectations and the two-year bond or whatever. But then when you get further out, it's like, okay, why does the growth picking up in Q4 of 2023 affect what people are going to pay for a bond that matures in the 2050s or whatever? No, I think there still is some sensitivity of policy that sort of reverberates through the term structure. And the sensitivity may decline the further out you go, but it's still there.

7:08So just for a number, every 100 basis point change in Fed policy expectations three to six month forward tends to sort of change long-term yields by about 40 to 45 basis points. And similarly, like every change in year ahead growth expectations tends to move long-term yields by five to 10 basis points. So yeah, the further you go out the term structure, the more, I think, idiosyncratic it becomes, but there still is sensitivity to what's happening to the underlying economy and to what's happening with Fed policy. So I think it's still there, just with a lower sensitivity than at the very short end.

7:41How do you actually go about, as a strategist, sort of decomposing the different moves into different factors or drivers? And I know that you have at JP Morgan, for instance, this fair value model of where you think treasuries should be trading. And I think last week, you were saying that you thought that yields had overshot fair value, which, you know, I'm guessing you didn't expect what happened over the weekend in Israel to actually happen. But it seems to have been quite prescient because we have seen yields come down a little bit. But how are you actually analyzing the different drivers of a move in rates?

8:17Yeah. So you've talked about the fair value model. I think that's a key input to what we do, because we try to identify empirically what have been the largest drivers of yields over time. And we can look back over windows of 5 or 10 or 15 years. And we've got a host of factors that are sort of always consistently in the framework. And we talked about Fed policy growth and inflation expectations being the three key drivers, like the triumvirate, so to speak. And then other factors, which at various points over the last 10 to 15 years have been important and less important. I mean, there was a time when with policy rates at zero and negative territory globally, we had the share of the bond universe that was trading at a negative yield globally because policy rates being anchored at very low levels helped anchor U.S.

9:00rates lower. And that was important but less important right now. So that starts. And, you know, if we have a sort of centering universe about where we think Fed policy growth and inflation are headed, that's a starting point. And you're right. Like when we adjusted for those factors, there was a point last week where it looked like we were trading about 35 or 40 basis points too high where, you know, you're talking about standard deviations before. That was something like a two and a half standard deviation move relative to fair value in our framework and one which we hadn't seen since this time last fall after the UK LDI crisis.

9:30Right, which was the other big bond sell-off. And really since the spring of 2020 too. So I think, you know, we take notice of that because it's hard to say, you know, I think we've all been pretty humbled of the fact that the economy has been resilient. It's been tough to call. But we have to have something that sort of centers like where should rates be and how far have they gone? And this was at least a flag to us that they've gone too far. You mentioned sort of factors driving the U.S. Treasury price and how those have evolved over time. Can you spell that out in a little bit more detail? I would be very curious to hear more about what is driving moves now versus, say, maybe pre-2020.

10:05Yeah. I mean, I think pre-2020, we just briefly talked about one of those factors. Low and negative policy rates elsewhere meant that even as the U.S. was increasing rates during the 2015 through 2018 cycle, that was something that helped anchor long-term yields at lower levels. And you could see the influence there when you talk about the hedged yield pickup for U.S. bonds versus most foreign currency pairs. And that has since, of course, eroded because basically every major developed market central bank has been increasing policy rates at a rapid rate. And the last of which that's out there, the Bank of Japan, we think at some point, will completely lose its yield YCC band and will at some point exit negative interest rate policy next year.

10:46So that was an important factor, which we now don't have as a factor in the model. The Bank of Japan, it was like about a month and a half ago or two months ago, like sometime in August. I forget because I have to admit like all these Bank of Japan headlines about whether they're going to like keep the 10-year zero or whatever. Like they all sort of blur. But there was like some news that happened. It was something out of the Bank of Japan that like changed the entire tenor of the market all at once. Can you remind me what I'm like forgetting here? Yeah, Joe, in late July, the Bank of Japan basically allowed JGBs in the 10-year sector to trade even wider around its sort of plus or minus 50 basis point target and effectively kind of gave you notice that at some point it was getting closer to completely removing that YCC.

11:29Because they're having their highest inflation in years too, right? Exactly. Okay. Exactly. So, I mean, I think on a partial basis, you can argue that was a catalyst as well. Can you talk about – when you talk about these foreign buyers, as you say, there's sort of like price-insensitive demand from a foreign sector. The disappearance of these price-insensitive foreign buyers, how much does that affect rates versus, say, just like rates volatility? By the way, this is why I really wanted to get Jay on for this podcast because he wrote a great note about a year ago basically talking about the retreat of price-insensitive buyers in the form of foreign central banks and the Fed as well as it was winding down.

12:07its balance sheet. I think I wrote it up under the headline, JP Morgan is worried about who's going to buy all the bonds. And at the time, it got a lot of pushback. But fast forward a year, and again, it seems like you were broadly directionally correct. No, I think it's an important driver over a longer period of time. It's hard to say, and Tracy, you said this before, whether it's the proximate cause of the sell-off. But I think in the background, it's something that's contributing to what's going on. Because And to us at J.P. Morgan, we look at three sets of buyers who have been the main price insensitive sources of demand for the better part of the past two decades at various points.

12:44And you talk about the foreign demand story. I mean, we know that FX reserves peaked about seven or eight years ago. The dollar share of those reserves have been coming down. But there was a point in time at the beginning of the century where FX reserves were growing so rapidly and the share of those reserves held in dollars were so rapidly that the deposit of that savings into the U.S. I think was something that kept long-term rates low. And you remember Chair Greenspan talking about this and the conundrum in 2005 about why long-term rates were not rising even as the Fed was tightening. So that's a key driver right there.

13:14And we look at it. FX reserves, we don't really expect to grow appreciably from here. And we're not in the de-dollarization camp. But the dollar share of those reserves have been on a downward trend as central banks globally have been diversifying. So it's just saying that if that was a tailwind for rates for the better part of the first half of this last 20 years, it's not there. The second one, and this was more local, are the U.S. banks where they bought about three quarters of a trillion of treasuries over 2020 and 2021 when supply was heavy, largely due to the fact that deposit growth outstripped loan growth.

13:47And now we know deposits have stopped coming down like they did in the spring, but they're not growing. And I think one would think even as deposit growth picks up that banks, after what's happened here, might, generally speaking, bias their purchases shorter along the yield curve with less duration risk. And then the final piece of the puzzle is the Fed. And I think we lose this, that even though we're coming to the end of the Fed policy rate tightening cycle, or we think it's actually concluded, balance sheet policy is operating in the background. And just as the BOJ, Joe, was really important at the end of July, I think Chair Powell's comments at the July press conference were as equally important, because a reporter asked him about whether the Fed could continue to do QT while it actually lowers interest rates as inflation comes down next year.

14:27And he made the point that you'd be normalizing both. The policy levers may be in opposition, but you're normalizing the balance sheet as you're normalizing rates. And I think the extended runway for QT matters because we found over a longer period of time, the Fed's stock of holdings matters for yield levels. And as that unwinds, that should slowly keep long-term rates anchored at higher levels and re-steepen yield curves.

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16:55Just going back to some of the short term catalysts here, you know, we mentioned term premium in the intro. Term premium is one of those concepts. I feel like it gets bandied around quite a lot. Not everyone quite understands what it means, but also there is no consensus. Like myself. I'm about to learn something that I've always been wondering about. But see, you're missing out, Joe, because you should just start saying term premium. Just blame everything on the term premium and just use it as a scapegoat for any move that you don't agree with or that you are on the wrong side of. That's how most people seem to use it.

17:27But OK, maybe just to begin with, what is the term premium and what has happened to it in recent weeks? Yeah, so the term premium, and you're right, it's nebulous term, I think, is the extra compensation required for investors to buy longer duration assets. That is a perfect definition that I'm pretty sure I have used in my own copy before. I just made sure I Googled it before. But I think there's a number of ways to look at it. And I think we can start and just talk about our fair value framework. And I think we can say everything outside of these fundamental drivers, one might possibly attribute to term premium that in the absence of being able to explain with growth and inflation and Fed policy expectations that that's a driver there.

18:07There's also a series of very widely watched academic models. There's the ACM model from the New York Fed, the Kim Wright model that the Federal Reserve Board in D.C. watches, which are a series of, I think, no arbitrage term structure models, which are kind of mean reverting in nature. And those were sitting relatively low until recently. And they actually would attribute most of the sell-off over the past six weeks to term premium. You know, I think we've done a paper on this and we think that there's some idiosyncrasies with the way that these models are constructed because they are sampled over a period of declining rates that they attribute a lot more to changes in policy expectations than term premium.

18:42So at turns, they can be less sort of influential or less, I think, insightful. They're still very valuable, just less incisful at these turns. And then there's finally more empirical ways to measure it too because there's survey-based measures of where economists expect policy rates to be, like the survey of professional forecasters and the survey of primary dealers where you can observe where economists think policy rates will be over the next five to 10 years. You can compare them to 10-year rates to get a sense of the extra compensation that's required. Right. So this is the key, right, because the basic idea is a long rate is just a series of overnight rates.

19:14And so that gap, if you have some estimate of where the overnight rates are going to be over the next 10 years, then you look at the yield, then theoretically that gap is the term premium. The term premium, exactly. Can you talk about sentiment? And, you know, it strikes me, Tracy, that we were recording this basically literally a month after we interviewed the bond king, Bill Gross, in which he said, he doesn't own any bonds. And so it really strikes me that was like, well, people hate bonds right now. Like people really hate them. And everyone like in that month, since we talked about, first of all, when we had that conversation, the 10 year was closer to 4.2%.

19:48So very timely call. But you know, in that month, I do not recall there's so much talk about the deficit. There's so much talk about all of these things, higher inflation, higher for longer, we can't get it under control. How do you measure sentiment and how much does that drive some of these moves? I'm glad you asked that, Joe, because I think it can be really influential over shorter periods of time, say four to six weeks. So there's a host of metrics that we like to watch from the CFTC's data on sort of speculative positioning and interest rate futures, some more empirical models that sort of track the performance of hedge funds and asset managers.

20:25But my favorite, and it's very close to my heart because it's been something I've been working with for like more than two decades, is our weekly JP Morgan Treasury Client Survey. It's a bit of a misnomer because it's really our duration survey of the aggregate exposure of our rates franchise. And every week, we ask the same number of clients in our franchise, whether they're long, neutral, or short duration, either outright or relative to benchmark. And we found that when that measure sort of moves very sharply away from average levels, it can have a mean reverting effect on yield the opposite direction.

20:56So you talk about sentiment. I think everyone through the spring and summer was trying to handicap when the Fed would be done raising rates, thinking the next move is going on hold, which would be the precursor to rates moving lower. And our survey back in July and August was as long as it had been in over a decade. And it gave you a signal that over the next five to six weeks, there could be some risk that rates move higher on a systematic basis. And that's what we've had. Now, walk that forward in our latest survey, which is about a week old right now, is back at its most neutral level since April.

21:25So I get the sense that perhaps part of this move over and above the fundamentals could be investors reassessing those duration positions as we've priced higher for longer, where you talk about the supply dynamic here at work, maybe that's in the background against the backdrop of large deficits. But I think sentiment is a really large driver over shorter periods of time. So two questions on that. One, there has been this argument that as yields go up and prices go down, you are going to see some maybe buy the dip buyers start to come in and support the market. So one, would you expect that to happen?

21:58And then two, on the duration portion of it, like how much appetite is there for duration structurally in the financial system nowadays? And I guess a simpler way of asking that is why buy a bond at all, especially at a time, you know, what I understand maybe you're a pension fund and you have long liabilities and you're trying to match them or something like that. But on the other hand, you do have the Fed really taking a harsh look or a harsher look at duration risk, telling banks, big buyers of bonds, as we were discussing earlier, that they are going to be looking at interest rate exposure and things like that.

22:33So what is the attraction of bonds at all in the current market? No, I think that's a great question. And I mean, bonds are an investment alternative that are viable for the first time in 15 or 16 years here, right? I mean, you talked about it, about the opening treasury yields hitting, you know, pre-GFC highs across the curve. You know, aggregate fixed income yields for like an aggregate fixed income bond index are probably still close to 6 % right now. And so I think that's a viable investment alternative just for a broadly diversified portfolio. So I think that means there's probably a pool of asset managers that could have demand for bonds over time.

23:07But I think that's only one piece of the puzzle because it takes a very attractive yield level, which we've got, but also it takes sort of more stable returns. And you started to see that at the beginning of the year when yields started to stabilize, inflows into bond funds started to accelerate. But that sort of petered back when volatility began to pick up. And because now, year to date, we've got fixed income returns negative for the third consecutive year. So perversely, I think it's a little bit of like a chicken and egg. You need the attractive yields, but you need stable returns as well.