U.S. Treasurys are regaining their appeal as a safe haven investment, driven by investor concerns over economic instability and the speculative AI trade. Recent market movements show a breakdown in the traditional correlation between oil prices, Treasury yields, and stock futures, suggesting a shift in investor sentiment. With yields returning to historical norms and corporate credit facing increased risk, investors are increasingly looking towards the relative safety of government bonds.
U.S. Treasurys are experiencing a resurgence in popularity among investors seeking a safe haven amid economic uncertainties and concerns surrounding the future of equity and credit investments tied to the data center build-out. Previously, an increase in oil prices would reliably lead to higher Treasury yields and lower stock futures due to inflation fears, making oil price monitoring a key indicator for bond and stock movements. However, this correlation has recently broken down. For instance, on a recent Thursday, Brent crude futures climbed 4%, while 10-year Treasury yields fell by 18 basis points and the S&P 500 index dropped 1.2%.
Several factors are contributing to this divergence, some likely short-term and others indicative of longer-term shifts. For younger investors, bonds might seem like an unfamiliar investment. For 15 years, multiple rounds of quantitative easing suppressed yields below 3%, often near zero, making them uncompetitive with stocks. More recently, the market has witnessed the worst long-term bond bear market since the era of Alexander Hamilton, as yields have been repriced significantly higher.
While it's tempting to forecast continuously rising yields based on recent poor performance, current levels suggest a reversion to the historical mean. The 10-year yield has returned to its long-term average, hovering just above its 100-year moving average.
The End of the Stock Rotational Trade
Meanwhile, investors are re-evaluating the Artificial Intelligence (AI) trade. For much of the year, market focus was on sector rotations. Investors concerned about the substantial, upfront capital expenditures of hyperscalers and their monetization capabilities would sell those stocks and buy semiconductor stocks. Conversely, those feeling overexposed to the AI trade would rotate into less exposed stocks, often overlooking the potential for a broader AI slowdown to impact the entire economy.
"It's been almost a full year since the last 80%+ downside volume day on the NYSE," notes Jonathan Krinsky, chief market technician at BTIG. This sentiment could shift if investors begin rotating out of stocks and into bonds, rather than simply moving into other stock sectors during times of uncertainty.
Credit Now Matters
Investors considering a rotation into bonds may want to avoid corporate bonds, as many companies have significant exposure to the AI build-out. The assumption that hyper-profitable data center expansions would offset higher borrowing costs, and that well-capitalized bond investors would readily absorb new debt issuance, is being tested. Corporate bonds that were priced for a low-yield environment with historically tight spreads are now appearing less attractive, leading to widening spreads.
The impact has been most severe in riskier credit segments, with high-yield spreads widening by approximately 70 basis points since late September. For corporate bonds rated CCC or lower (considered the riskiest), spreads have increased by over 200 basis points during the same period.
Fiscal Issues Are Relative
As the U.S. national debt surpassed $40 trillion this summer, investors began demanding higher returns to finance the government's growing borrowing needs. While the near-term deficit trajectory remains largely unchanged this year, the government's interest expense could increase if interest rates stay elevated or rise further. If interest expenses exceed nominal GDP growth, a debt spiral could ensue. Although such a scenario is years away for the U.S., other countries like France are already facing this reality.
The bonds of nations with more severe fiscal challenges have become uninvestable for some, benefiting U.S. Treasurys through a rotation. "For the first time in a while, Treasurys are enjoying haven status. You have weakness in tech, an escalation of risk in the Middle East and higher oil. On a relative basis Treasurys start to look like the safe place to hide again in the short term," states Larry Holzenthaler, senior portfolio manager, fixed income at Catalyst Funds.
Demand for Treasurys began to pick up when 10-year yields reached 5.3%. At these levels, pension funds aiming for a 6% return can allocate a larger portion of their portfolios to fixed income with reduced risk. The psychological barrier of the 5% yield, which previously acted as a sell signal for bonds last month, now seems to be fueling a Fear Of Missing Out (FOMO) among investors concerned about missing out on a risk-free return above 5%.
A Cyclical or Secular Shift?
Near-term uncertainty surrounding AI and a series of upcoming catalysts could drive robust Treasury demand in the coming month. However, the long-term outlook remains uncertain, as it's unclear whether investors will trade the guaranteed returns of Treasurys held to maturity for bets on an AI-driven future.
"We do still believe that hiding in Treasurys is a risky move longer term. You still have fiscal concerns and high inflation. Unless you're positioning for a recession, we believe assets like short duration corporate credit offer a more optimal risk/return," advises Holzenthaler.
