return of the bond vigilantes

*US Treasury issuance has exploded higher since the debt ceiling raise in June. Source: Bloomberg. Click for larger image*

Just as inflation angst appeared to be on the retreat, fiscal worries took center stage in September with massive Treasury issuance (chart) sparking a fresh surge in rates and a broad-based selloff in almost all areas of the equity and bond markets (S&P 500 -4.8%, Nasdaq 100 -5.1%, Aggregate Bonds -2.2% Sep). With fiscal spending having counteracted much of the Fed’s efforts to slow the economy over the past two years, the return of the market’s fabled “bond vigilantes” threatens to remove a significant source of economic support just as stress from rising rates is growing extreme.

Though only the first of three crisis conditions were met (see diagram below) during the month, TCM strategies benefitted from initial negative-beta positions deployed after mid-month VIX signal inflections, with Alpha Seeker (+1.1% Sep) recording its best month of the year while Risk Managed Indexing strategies (Tactical Beta -4.4% Sep, Tactical Q -4.7%) gained ground on their respective index benchmarks. Should this signal move on to crisis territory, it would mark one of the lowest-cost hedge entries in the past six years, comparable to the outstanding experience in Feb and March 2020.

*Crisis Checklist, September 2023. Source: TCM*

gut check

*S&P 500 Index, Jan 2020 - Sep 2023. Source: barchart.com. Click for larger image*

Having stalled in a nauseating range for two years (chart) while the interest rate ratchet continues to tighten, stocks are at a very fragile juncture. While a return to lower rates could very well produce a new bull market, the possibility of systemic failure is also growing and in a highly-leveraged system, the consequences are likely to be severe.

In this environment, it is impossible for investors to be comfortable. Whether from fear of missing out or fear of losing money, anxiety to “do something” often leads to allocation errors just as the cost of making one is at its highest. Rarely do investors look back fondly at these decisions and while it may not be the best sales pitch, discipline is often the most reliable way through.

For TCM, this means continuing to deploy protection only after crisis signs are observed (see “Wait Watchers” in our Aug 2023 commentary). Unlike expensive continuous hedging, the goal of this approach is not to reduce portfolio volatility, but to use the “anti-volatility” of VIX exposures like an airbag to cushion the effect of rare but impactful market crashes.

To our knowledge, this is the only strategy that produced a profitable hedge over the last market crisis cycle ended March 2020 and although it may create unfamiliar tradeoffs, we expect the same upon completion of the current one (see diagram). Given current conditions, that day may not be far off.