Nearing a capitulation bottom in the bond market?

Last month I wrote an article called "Don't fight The Fed". It dealt with the effects of rising interest rates on the valuation of stocks, and emphasized that the US central bank, the Federal Reserve, has both raised interest rates very quickly, and is also in the process of reversing the enormous injection of capital they made into the bond market through their so-called "quantitative easing» operations.

Since the article was published, we have had a month of large fluctuations in stocks, but with only a marginally negative development in total. At the time of writing, the S&P 500 and NASDAQ 100 are down -0.14% and -1.66% respectively in the last month. The strengthening of the dollar has also been relatively modest, with the dollar index DXY up only 0.47%. None of this is enough to determine that we have any definitive change in trend. Stocks are still down, and the dollar is still up over the last month. However, the speed has been lower and the fluctuations around these levels considerable. It could mean that we are entering a new phase.

What has really continued at high speed is the rise in long-term interest rates and with this the fall in the prices of longer bonds. These two are, after all, a mirror image of each other.

Among the very largest players in national and international capital markets are pension funds. Some of these manage their funds themselves, while others leave it to large and smaller asset managers. Often, however, they hold variants of the same type of portfolio, which is a mixture of mainly stocks and bonds. The typical mix has been a so-called 60/40 portfolio, with 60% shares and 40% bonds. Historically, these have often acted as a balance for each other, as typically "bad times" have resulted in lower stock-prices, but also a fall in interest rates and therefore a rise in bond prices. This year, however, both stocks and bonds have fallen sharply. Economists say that we have now had the worst start to the year for a 60/40 portfolio in the last 100 years. This thus includes both the hard 30s, two world wars, the IT crash at the turn of the millennium, the financial crisis and Covid-19. We are looking at a fall of epic proportions. It has never been worse than now.

In the month behind us, the central bank in Great Britain had to intervene in the bond market in the UK when the selloff in bonds was so great that several of the country's pension funds ended up in a liquidity squeeze. It eventually cost the position of both a finance minister and a prime minister. Not something we see every day.

In the US, however, the downturn in bonds has continued unabated, and the rhetoric from the Federal Reserve gives no hope of any immediate change. Movements of this type have both short-term and long-term consequences but can typically lead to something "big" breaking. What it turns out to be, we have various examples of throughout history. Nobody knows what will happen this time, but the movements we are seeing now must lead to extreme stress in many portfolios.

This is most clearly illustrated through the chart on TLT below. This is a widely traded US-listed ETF that holds a portfolio of US government bonds with an average maturity of 20 years. At the time of writing, TLT is -37% so far this year, -21% last 3 months and -11.5% last month. It's extreme.

Such movements can lead to actors being forced out of positions at almost any cost. You rarely know about this before it happens, but in the price charts such situations remain afterwards as capitulation bottoms (sometimes called "puke bottoms").

The typical character traits of such a situation are:

1. An extraordinarily long continuous downward price movement.
2. The price movement accelerates and often has leaps (gaps) overnight.
3. Increasing trading volume at the same time as prices fall.
4. Momentum indicators reach extremely oversold levels.
5. The fall culminates in a strong intraday reversal on high volume.

It is only in retrospect that we have the facts, but TLT is starting to tick off many of the points above and is worth watching closely in the days to come. If TLT can print a bottom, it will have important ramifications for the whole market.