: This researcher came up with a key insight for why bonds sell off — six years ago. ‘People thought it was a strange topic.’

by | Oct 7, 2023 | Stock Market

Long-term bond yields have been spiking, in response to the Federal Reserve letting its bond portfolio slowly roll off as the U.S. Treasury has been selling debt to fund the government’s spending. The move caught Wall Street and investors worldwide almost entirely by surprise. But there was a research paper that largely predicted exactly this scenario, written six years ago, to understand the Fed’s unwinding of what was then a $4.5 trillion portfolio. Now the Fed balance sheet stands at $8 trillion, having peaked around $8.9 trillion.

It was written by a University of Michigan doctoral candidate, who came up with a critical insight: The market’s ability to swallow up issuance depends on the correlation between the bond and stock markets. “At the time, people thought it was a strange topic,” recalled Steve Hou, now a quantitative researcher for Bloomberg. He did say that some central banks including the Bank of Canada and the Cleveland Fed took notice. “The scenario which I envisioned, where we could end up a different regime where the stock-bond correlation will no long remain deeply negative, causing there to be a sharp price elasticity for bonds, seemed very far-fetched at the time.” When the bond and stock markets move in different directions, bonds are a good hedge for stocks, making it easier for markets to soak up new Treasury supply, wrote Hou in the researc …

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