By Mike Dolan
LONDON (Reuters) - Unsure which way the cookie crumbles from here - investors are being tempted to drop the bond.
This was supposed be the year when the 'safe' investment buffer outperformed - recession and rate cuts were due and locking in hefty long-term, investment-grade coupons and sub-par bond prices were expected to easily trump ebbing cash returns while avoiding assumed company earnings turbulence in equity.
It hasn't worked quite like that.
As the second half of the year kicked off this week, something of a capitulation of the bond trade seems to be underway. 'Soft landings', returning real wage growth, higher-for-longer central banks rates and artificial intelligence excitement have all swept recession and rate cuts off the table and stocks climbed.
With labour markets still tight as a drum and underpinning consumption, central banks are fearful that very resilience may scupper the last leg of the disinflation process and are still pushing rates even higher to ensure credit stays tight enough to get inflation back to 2% targets.
Global stock markets have surged 10% to 15%. Global bond indexes have done nothing or are in the red. ETFs capturing 7-10 year U.S. Treasuries are down almost 3% year to date and shorter-dated 1-3 year versions are down almost 1%.
The broadest measures of government and corporate bonds have just stuck in mud. The Bloomberg U.S. Aggregate index and global Multiverse index are flat on the year - up less than half a percent.
Double down, or throw in the towel?
While many asset managers are sticking with their bruised recommendations, a lot of cloth also appeared to hit the canvas this week.
Two-year government bond yields are soaring. With June U.S. jobs growth going up yet another gear, U.S. Treasury yields hit 16-year highs above 5%, German equivalents hit their highest in 15 years and British gilt yields scaled 2008 peaks.
The selloff was across the curve; 30-year Treasury yields topped 4% again to stalk the year's highs while 30-year gilts were on course for their biggest one-day hit since the UK budget farce of last autumn.
These are not recession trades - though they could brew one.
Investment logic can sometimes be so circular it's dizzying.
Another sharp surge in borrowing rates and bond yields may yet seed the absent economic downturn while undercutting long-term discount valuations of some of the tech companies and mega caps the were the vanguard of this year's stock rally to date.
Stocks also juddered this week in the latest bond quake.
But for now, asset managers' pain in reporting midyear underperformance seemed to be dominating a rethink of the 'year of the bond' regardless.
BOND FUNK
As recently as mid-June, Bank of America (NYSE:BAC)'s global investor survey showed the most overweight positioning in bonds for eight years - alongside a net underweight in equity more than two standard deviations below long-term historical averages.
For JPMorgan (NYSE:JPM) strategists, the past two weeks may well have seen a scramble to rebalance already into the half-year mark -- possibly explaining some of the violence in the sovereign bond rout this week too.
JPMorgan pointed to a sharp increase in net long positions on U.S. equity futures by asset managers and leveraged funds as "they appear to have capitulated on their previous bearish stance and turned overweight". This sudden shift took net long position as a share of total open interest from well-below average levels in early June to above average levels this week.
Although JPMorgan's analysis of mutual fund, pension fund and corporate demand and supply metrics argued much of the rebalancing from the dire 2022 skew was now "exhausted", it's possible some further unwinding of the bond side is yet to run.
So what happens next?
At its most basic, the economic and rates picture for the remainder of the year remains finely balanced. The start of the second-quarter earnings season next week will tell a tale, with more clarity sought from another likely Fed rate hike on July 26 as many still await the lagged effects of rate rises to date.
One way to view the equivocal outlook is that full-year consensus earnings growth forecasts for both the S&P500 and Europe's Stoxx 600 are now both exactly zero - though that rises to 12% for 2024 for the S&P500 and 8% next year for Europe.
Another is that there is no full Fed rate cut from current levels now priced for more than a year - almost two hikes in the interim, only partially unwound by then.
But if a full-year recession in either the wider economy or earnings doesn't now materialise, and rates don't come down again for more than 12 months, then bonds may simply get squeezed out of portfolios by mix of uber-safe attractive cash rates of 5%-plus or equity and alternatives that may frontload the earnings upturn.
For all but longer-term pension and insurance funds or banks, bonds may be neither fish nor fowl for a while to come.
The opinions expressed here are those of the author, a columnist for Reuters