What Bond Traders Are Saying: "It Won't Be Pretty"
With rates seemingly flip-flopped today (yields higher as stocks drop), we thought it worth skimming what the smart money in the bond market is thinking. As RBS Strategist Bill O'Donnell warns, "Janet must act like a diving instructor, hoping to bring levels to the surface without giving the economy the bends. What makes it really risky for Janet is that financial sector regulation has created a ‘one-way valve’ in secondary market liquidity. Nobody really knows how the system will hold up under duress." This is confirmed by Scotiabank's Guy Haselmann who fears, "the Fed will have difficulties controlling market gyrations and its potential loss of credibility from troubles that are likely to arise from its exit strategy."
RBS strategist Bill O’Donnell writes in client note.
“It won’t be pretty, regardless. My assumption is that investors will sell or hedge where they can first (ETFs or hedge in ever-liquid USD swap spreads) and that’s one of the many reasons why I fancy 5yr swap spread wideners as a medium-term trade”
“I won’t get long-term bearish on bonds unless/until there are clear signs that animal spirits have re-emerged in the US economy or that EU rates are lifting off the floor”
Other observations from morning notes by strategists and traders:
CIBC (Tom Tucci)
“The last several long end buybacks have been price extremes for the day. This indicates to me that the only real buyer of bonds at current levels is the Fed”
Credit Agricole (David Keeble)
“More interest is focused upon the curve shape and we’re beginning to feel that the consensus that the curve will continue to flatten is losing some adherents”
“We are reluctant to throw in the towel on the 2-5Y and 3-5Y flattener trades, believing that their large movements are only just beginning”
CRT (David Ader)
“Have never encountered such a sideways market for such a long period of time; there was a time when we would say it was coiling in advance of a big and abrupt move, but that doesn’t seem the case now as gradualism and tweaking seem more the case”
ED&F Man (Tom di Galoma)
“Still regard the pension extension and the need for duration (and lack of it in the market) as the overriding concern for the market place. Look for 10yrs to trade in a 2.6% to 2.4% range over the near-term”
FTN (Jim Vogel)
“With yield curves unflattening, better relative values have shifted toward slightly longer Treasury maturities”
“Last week’s abrupt move toward a steeper curve really was a short-term reversal of over flattening through most of July”
TD (Gennadiy Goldberg)
“Every piece of employment data will now be even more closely scrutinized, with investors attempting to gauge whether wage pressures (the missing piece of the labor market puzzle) are building”
“This has the potential to increase volatility in the Treasury space, with any surprise in wages now inextricably tied to the market’s timing for the first Fed hike”
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We leave it to Scotiabank's Guy Haselmann to conclude:
Markets recently have had a perverse reaction to economic data. Equity markets seem to fall on strong data and rally on weak data. In such, it seems fair to conclude that Fed accommodation continues to trump economic fundamentals. Therefore, it may be fair to conclude that a tepidly growing economy is likely best for risk assets. At the moment, this might be consistent with the Fed’s forecasts of modest improvement that will allow the FOMC to withdraw accommodation gradually and methodically. However, the odds of such a convenient outcome are small.
Market volatility is highly likely to rise, because the FOMC’s future path will likely deviate from current forward pricing. There is a wide range of economic projections amongst market participants who will be forced to reassess and shift positions as data unfolds. Fortunately for the Fed, after QE ends in October, the FOMC will have greater flexibility.
However, the Fed will have difficulties controlling market gyrations and its potential loss of credibility from troubles that are likely to arise from its exit strategy. If the economy strengthens, markets will be forced to price in a more aggressive Fed as consensus builds that it is ‘behind the curve’. If data weakens, the market will worry that the Fed has no ammunition; and regardless, markets would question QE’s effectiveness. Neither outcome is good for equities or credit, but long-dated Treasury Bonds would benefit. I maintain my prediction of a sub 3% 30 year by year end.
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