The Fed is hiking, core inflation is heading higher and the job market is robust. So bond yields are going higher, right? At least these are some of the typical arguments we hear for being short duration in fixed income now. As it has been in the past when the Fed is hiking and unemployment going lower. However, history suggests that this can be a dangerous analysis.
We find that there is mainly one key driver for a bond bear market: whether the cycle is accelerating or not. Below we use the US ISM index as a gauge of this. As the chart below shows, over the past 25 years the 11 bear markets have all taken place while ISM was rising. The level has not been important. A high level of ISM is not enough to push yields higher if ISM is moving lower. Actually, a rise in ISM has been a necessary, but not always sufficient, condition for a bear market.
An acceleration in the cycle has also been a key ingredient in the latest ‘reflation’ selloff in bonds. ISM has increased sharply over the past three-five months. It’s also been a key ingredient in the reflation case we have pushed since November. Here we presented a checklist of four key factors for reflation with acceleration in the cycle being a key factor. Rising commodity price inflation was another one.
With this in mind, we see three reasons investors should be careful with short duration positions currently:
1. We are close to a peak in ISM manufacturing
2. Headline inflation is heading lower from here
3. Short duration is a crowded trade
