Early in the year everyone in finance, absolutely everyone, said that it was only a matter of time before the 10Year, then at 3.0% would rise to 3.5% if not higher. As a result, everyone got short. A few months into the year, the great recovery story has not only failed to materialize but Q1 GDP printed at its worst since 2011. And while equities, which these days are traded more by central banks and algos than actual institutional and retail investors, have been quick to accept the scapegoating of the "harsh weather" as the excuse for the economic slide. Bonds, have been very much unwilling to accept this excuse, and just yesterday dropped to a level not seen since the spring of 2013: 2.40%, making bonds some of the best performing assets year to date. This has left everyone expecting "pleasant" inflation not only with very unpleasant P&L losses, but scrambling to explain why they were so very wrong in their call.
Today, for the first time, one bank, Citigroup, has been kind enough to offer a mea culpa, saying "fair value of long-term rates may be lower than we and other market participants may have judged them to be at the beginning of the year." That said, this tongue-in-cheek apology is wrapped by yet another justification for why rates are where they are (hint: Citi, clearly, has no better idea than anyone else, especially considering their previous forecasts on the matter), and why - all else equally priced to perfection - should finally begin to rise.
We hope to revisit this topic at the end of the year and again compare the result to what the gradually changing consensus says today. In the meantine, here is Citi's mea culpa:
The 10 bp decline in 10-yr Treasury yields this week has intensified the debate around the slide in Treasury yields since the beginning of the year.
The first leg down in yields – through to the end of the first quarter - could be attributed to the significant growth disappointment; the Citi Growth Index plunged in Q1 as growth surprised to the downside. Since then, however, we have seen rates slide even as the indices have recovered (Figure 2).
We review some plausible explanations for continuing rally. Our assessment is that:
- The reduction in the significant short base in the market has prevented rates from increasing in response to the improvement in growth data. Based on the indicators we track, the short base has declined materially and rates should become more responsive to further improvements in economic data.
- Offsetting this bearish development, fair value of long-term rates may be lower than we and other market participants may have judged them to be at the beginning of the year. Consensus economist forecasts called for a 3% growth year. Despite improving growth data, it remains to be seen whether we can actually sustain those growth rates over successive quarters. If growth does not sustain well above trend levels, the market would need to reassess fair value of long-term rates.
- We remain neutral on duration. While the position clearing is encouraging, rates are not sufficiently misaligned with fair value at current growth trends. We recommend two alternatives to an outright short duration position: long 5-year breakevens and a 2y1y-3y1y steepener.
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Some further drill down on the real reason why bond yields have slid:
Growth disappointment drives fair value reassessment
2014 should have been the breakout year for growth. The fiscal drag from sequestration and tax hikes was fading. Household net-worth had increased by a remarkable $10 trillion; almost 75% of personal disposable income affording an opportunity to consume out of wealth. Expectations were that GDP growth would substantially exceed the 2.2% trend level as estimated by the CBO. Specifically, the Fed and private sector forecasters were looking for growth in the 3% range.
Instead we got a negative quarter. Since headline growth numbers are dramatically affected by inventory adjustments, we prefer to look at our Growth Index as a measure of the underlying trend in growth1. By this measure the underlying growth trend in Q1 was ~2% and has subsequently improved to 2.8%.
While this is a notable improvement, it has to be viewed in the context of the tailwinds going into the year. We estimate that wealth effect impulse from the equity and housing market rally itself should have generated close to 3% growth. This should have been supplemented by the still low rate levels which should have boosted growth well above 3%.
The fact that growth has continued to come in below expectations suggests that rate levels are not as stimulative as we would have expected. If we take the 30-year mortgage rate as an indicator of the representative borrowing rate2, it averaged 4% over 2013 compared to the current 4.1% level. Perhaps mortgage rates need to be lower than 4% to stimulate the desired growth!
While we are reassessing our yield-curve fair value methodology, it does appear that a 4.1% mortgage rate may not be absurdly low given the current growth momentum. Our Growth Index (currently 0.12) would need to get to 0.3 or higher on a sustained basis to signal that current yield levels are very stimulative and need to move higher.
Still, here is the strawman: shorts are supposedly covering.
Positioning: clearing out the short base
It is no secret that many investors came into the year short duration on the back of very strong data – our Growth Index topped out at 0.4% in mid-February – and the stock market rally. This weight of positions has capped Treasury sell-offs in response to the improving growth data.
There is evidence that the short base is being cleared. This is evident in the CFTC positioning data but also in two other measures that we track; the estimated duration positioning of large money managers and a monthly duration survey that we conduct. All three measures indicate a considerable lightening of the short base from two and three months ago.
The close out of short positions has probably exacerbated the decline in Treasury yields in response to the general data weakness. With lighter positions, rates are more likely to respond to data strength. This is a bearish development.
So a bearish assessment based on an estimate based on a survey in which the respondents reply the way they wish others would reply so that someone takes the first step, with nobody actually acting, or, said otherwise: actions speak louder than surveys?
We'll know soon enough if this is yet another incorrect assessment. For now all we know is that the hedge fund community is not only underperforming the S&P500 for the 6th year in a row, but is outright losing money so far in 2014.