The Bond Market Is About To Get Intimidating Again
Authored by Simon White, Bloomberg macro strategist,
As the bond rally runs out of steam, the case for shorting Treasuries is becoming increasingly compelling.
The bond market that US political advisor James Carville wanted to be reincarnated as is about to get intimidating again.
The rally off last October’s lows is fading, and there are now a litany of reasons why longer-term Treasuries are likely to soon fall in price, taking yields higher and supporting the yield curve:
Global financial conditions are easing
Excess liquidity is rising
Inflation is becoming entrenched
An increasingly precarious fiscal situation
Declining overseas demand for USTs
An expected jump in issuance when the debt-ceiling is resolved
First of all, let’s get the debt-ceiling elephant out of the way.
In the two previous debt-ceiling episodes in 2011 and 2013, bond yields mostly fell. Perversely, in a risk-off environment Treasuries were the only safe-haven asset, even if they were at the center of why risk was elevated in the first place.
We may get the same knee-jerk reaction this time, but that’s just a selling opportunity. Net Treasury issuance has slowed to a crawl ahead of the debt-ceiling “X Day”. But if it is resolved (as is still more likely than not), issuance would be ramped up rapidly, with the surfeit of supply weighing on prices.
But even without the debt-ceiling tension, we are at a turning point in the cycle. Short-term rates are peaking, not just in the US, but around the world. This is captured in the Global Financial Tightness Indicator (GFTI), a diffusion of G20 central-bank rate hikes. It has been rising, and this upturn should gather pace as central banks increasingly focus less on inflation and more on growth (despite what they may currently say – remember, talk is cheap).
As the chart below shows, rises in the GFTI precede rises in the US 10-year yield.
This might seem counter-intuitive: short-term rates peaking should mean lower longer-term yields. But what the relationship is saying is that once global rates have peaked, this allows the market to price in a future cyclical upturn for the US economy, which longer-term yields capture by moving higher today.
We can see the same sign of a yield upturn in excess liquidity.
Excess liquidity is the difference between real money growth and economic growth, and is beginning to turn up. Such environments tend to favor stocks over bonds as investors prefer riskier assets, so as to fully capitalize on buoyant liquidity conditions.
This cycle could see this preference turbo-charged due to persistent and elevated inflation. Equities are generally taken to be good inflation hedges, while bonds are not. This is actually not true: neither broad equities nor bonds make good inflation hedges.
Nonetheless, the perception will be enough to keep equities supported relative to bonds, at least in the first instance. This may already be happening, given equities have remained relatively supported and bonds’ rally has been lackluster despite increasingly recessionary signs. The specter of inflation is a reminder that this will not be a garden-variety downturn.
Indeed, bonds have yet to price in the embedded, above-target, and prone-to-flaring-higher inflation that’s likely to become apparent once the current disinflationary trend is over.
Term premium has remained remarkably becalmed in this cycle, but it is unlikely to stay that way. Heightened inflation expectations are the canary in the coal mine warning that bond holders may soon demand extra yield to lend money.
The debt ceiling has brought scrutiny to the US’s fiscal situation. It’ll likely be resolved by extending the debt limit, but that will not detract from the fact the US (like several other DM countries) is heavily, and increasingly, reliant on borrowing.
The US’s budget deficit is currently running at 8% of GDP, wider than any other major country, and already significantly more than where it was prior to previous recessions.
Safe haven or not, lenders to the US are becoming more alert to the deteriorating US fiscal outlook, making them warier of holding as many USTs. Foreign reserve holders have begun to diversify their holdings, while elevated short-term rates have raised FX hedging costs and kept buyers like Japan away.
Those waiting for a large short-covering-driven rise in USTs may be disappointed. Commitment of Traders positioning is very net short, but on a standardized basis it is much less extreme. A more holistic measure based on the inferred positioning of macro funds and CTAs, as well as JP Morgan’s Client Survey, is short, but not at levels that would suggest a brutal short-covering rally is on the way.
The halting rally after Wednesday’s softish inflation report is a sign momentum is shifting the other way. The bond market may once again be about do what James Carville envied it for: intimidate everyone
