Although Jerome Powell, the chair of the Federal Reserve, shook the bond market, investors had cause for optimism.
The U.S. Treasury market’s positive year-end seasonality could help investors get over their dissatisfaction with Fed Chair Jerome Powell’s statement that a rate cut in December is “not a foregone conclusion.”
The odds of a rate decrease in December were approximately 90%, according to the CME’s FedWatch Tool, before to Powell’s press conference last week. The current odds are 72%.
The fact that the Treasury market shows a rather regular seasonal pattern, with prices peaking in the late fall and bottoming in the spring, is a plus for bond investors at the moment. The chart below plots this pattern.
Monthly averages since the early 1970s are shown in the graphic. Since the U.S. Treasury Department started selling Treasury notes and bonds through open-market auctions on that date, that start date was selected. “Seasonal Variation in Treasury Prices,” a 2015 research published in Critical Finance Review, states that “there was very little seasonal variation in Treasury note and bond returns prior to this market-driven price-setting mechanism being in place.”
The research stated: “However, after auctions were introduced and Treasury issuances began following a regular, predictable schedule… we demonstrate that seasonal variation became a stable feature of the Treasury returns.”
When concentrating on trailing two-month results, year-end seasonal strength is very noticeable, as the preceding chart illustrates. While the average Treasury return for December is not particularly noteworthy, when combined with November, it surpasses that of any other two-month period in the calendar. At the 95% confidence level that statisticians frequently choose for determining whether a pattern is real, the difference between the average return for the month of November and December for Treasurys and the all-month average is significant.
The cause of the seasonality in year-end Treasury
The mere fact that a pattern is statistically significant does not guarantee that it will continue. Numerous relationships that are statistically significant but completely illogical yet exist. Therefore, it’s crucial to ascertain whether there is a tenable reason why a pattern should exist in the first place before placing a wager on it.
At first, it seemed that Treasury seasonality failed this extra phase. The 2015 study’s authors examined and ultimately disproved a number of theories explaining why the Treasury market would display this seasonal trend. In particular, they investigated “macroeconomic seasonalities, seasonal variation in risk, the weather, cross-hedging between equity and Treasury markets, conventional measures of investor sentiment, seasonalities in the Treasury market auction schedule, seasonalities in the Treasury debt supply, [and] seasonalities in the Federal Open Market Committee (FOMC) cycle” – all of which rejected the hypothesis.
But in the end, the researchers discovered that “seasonally varying investor risk aversion” provided a tenable explanation. In particular, investors have seasonal affective disorder (SAD) in the fall, which affects their readiness to take on greater risk.
“The price of Treasuries should rise, resulting in higher-than-average realized Treasury returns in the fall,” the researchers write, “if investors experience a dampening of mood and hence an increase in risk aversion in the fall.” Treasury prices then decline in the spring as investors’ sentiment improves and their risk aversion lessens, leading to realized returns that are below average.
