Supply-related bond volatility creates tactical but no systemic risk

Highlights: Bond yields have been rising for several reasons. The most recent concern is bond supply by the US Treasury and US hyperscalers, resulting in underperformance of long-dated bonds. We don’t see an immediate trigger to stop the move, unless the Fed Chair manages to provide comfort at the Jackson Hole meeting next week. But while there is a risk of further short-term volatility, we note that real yields and term premia are already elevated, and Fed policy is unlikely to tighten, given the more mixed consumer-side data. As bond volatility can spill over into EM and stock volatility (especially IT), we see moderate tactical risks but medium-term opportunity.

• The sell-off is not led by the front end but by the back end. In fact, short-term yields are down because markets have reduced the number of US rate hikes they are pricing in, as core PCE inflation looks stable and US activity data have been a bit more mixed recently
• The sell-off in the back end points to two factors. First, markets may fear that the Fed has become less credible or predictable under the new Chair. We think this concern should fade as the Fed decisions are committee based, and policy will become clearer over time. So instead, it is the supply from US hyperscalers and the US government that are the key concerns currently. Supply from Germany and rising Japanese long-dated yields may have contributed too, as they offer alternatives. The moves are likely being exacerbated by CTAs and other hedge funds adjusting positioning and by the effect of convexity in mortgage-backed securities (as higher yields lengthen duration there and result in more forced selling)
• Government bond supply should not be a surprise, and corporate bond supply is not traditionally strongly correlated with yield levels. Recent corporate supply has been well absorbed. We also note that credit quality in IG and HY is not the key market concern currently, as spreads have remained relatively stable and corporate balance sheets are healthy. As a result, we remain comfortable investing in corporate bonds, mainly IG
• It is hard to pinpoint an exact level where yields will run into resistance. But higher yields can weigh on growth expectations (especially as growth is currently boosted by investment) and create equity volatility, which then lead to bond demand and cap yields. So, while the bond market concerns and positioning adjustments may lead to further short-term volatility, there is value in bonds in the medium term as real yields are near the highest in more than 15 years