Many are perplexed by the 'strength' in Treasuries as yields collapse despite a headline payroll print propagandized (choosing to be non-believers in the bond-market's all-knowing eye). As Deutsche Bank notes, for well established reasons, a multi-decade Pavlovian response to much stronger than expected US data has been higher Treasury yields, which usually provides some USD lift. Last Friday, this plainly did not work, which proved extremely costly for many in the trading community. At a minimum Pavlov’s dog choked, but is Pavlov’s dog dead? The short answer is no, but Pavlov’s dog may have taken off the summer.
As Deutsche Bank reports,
One explanation for the surprising bond and FX response to the NFP data has been to fit the data to the market price action. This will prove wrong. The April employment was genuinely strong. The last 3 months payroll changes are all above 200K and consistent with some growth acceleration beyond weather distortions. Even the most disputable aspect of the report, the decline in the unemployment rate was achieved with a decline in participation rate, but only back to December levels. US data did not support any ‘capitulation’ from the strong US growth story.
The bad news is that it obviously did not stop a capitulation of many short Treasury and short USD trades. Which raises a couple of critical questions – how can we reconcile the price action with strong US data, and what message is the price action conveying?
Treasury resilience – 11 reasons, or 11 excuses?
A starting point is to recognize that US Treasury resilience remains central to much of what is happening to markets and currencies this year. Without flow of funds data - Q1 data is due on June 5th - we do not have a complete picture, but here are 11 explanations for Treasury solidity:
(i) The Fed was right - the 'stock' effect is more important than the ‘flow’ effect, and the Fed’s large bond holdings, particularly at the back-end, will suppress yields far into the future;
(ii) The ‘flow’ is also bullish, given the scale of Fed QE relative to the shrinking deficit/issuance; and relative to the buying from other players including:
(iii) Central bank purchases of Treasuries;
(iv) Pension funds that are underweight duration and overweight risky assets after last year’s equity gains;
(v) Fed H.8 data shows Commercial banks are buying securities again, seeking yield/carry.
(vi) Against the above, there are very large net short leveraged positions – record CFTC Eurodollar shorts and very large 10yr equivalents;
(vii) Inflation data remains soft. Last week’s soft average hourly earnings and ECI data was notably benign.
(viii)The China/ BRIC/EMG impetus for global growth is still on the wane.
(ix) The Ukraine. The impact here may be subtle, at a minimum making Treasury shorts cautious.
(x) Equities reduced traction, has encouraged a global search for yield while lower vol has encouraged a shift toward carry.
(xi) Ongoing speculation of a lower terminal funds rate, including all the ‘secular stagnation’ talk.
Deutsche concludes, for some currency pairs like USD/JPY, a simple back-up in US bond yields should be a sufficient condition to see the currency follow suit. In contrast, for the USD/EM trade it is likely that something bigger is needed whereby yields break new ground either at the short or long-end to reinvigorate the short EM trade.
What remains clear is that the foundations of the strong USD story built on stronger growth and lagged inflation acceleration still stand, but that every part of this adjustment, including higher front-end yields, long-end yields higher, and curve flattening will be drawn-out, by the slow Fed tapering.
Greatest confidence remains in a view that the front-end is overly dovish by any metric, including the FOMC’s own forecast, and that this will be self evident by the end of Q3 at the latest. Pavlov’s dog choked. Pavlov’s dog is not dead, but may have taken off the summer.