On one hand, the recent surge in 10Y yields is precisely what one - and certainly we - would expect: after all, the official arrival of helicopter money in the form of $1,000 checks to most Americans means that people's expectations for government generosity repriced overnight, and now the political debate shifts to how much more free cash Americans should expect and for how long (with Bernie Sanders firing the first shot with a proposal to hand out $2,000 instead of $1,000). On this point, Jeff Gundlach predicted during his DoubleLine call yesterday that "the U.S. national debt likely to grow to $30 trillion in two or three years as spending explodes in response to the crisis", which means about $3-4 trillion in net issuance per year, and that upcoming supply tsunami is certainly sending bond prices lower, potentially dealing a deathly blow to the risk-parity/balanced "60/40" portfolio model.
Yet on the other hand, Treasury inflation breakevens have plunged to record lows as if the market is saying that despite this flood of new money, there will be no actual inflation as much as a decade in the future. To put it mildly, this is bizarre, and as BMO's Ian Lyngen writes this morning, "there are aspects of the overnight price action which resonate and others that confound. Mnuchin’s dire warning that the unemployment rate could spike to 20% in the absence of government intervention to address the coronacrisis had the foreseeable impact on the equity market; limit down. The shape of the yield curve has also performed in line with prior easing episodes with 2s/10s reaching 72.6 bp overnight and offering solace to those anticipating a cyclical resteepening."
But it is the outright levels of 10- and 30-year yields at 1.21% and 1.83%, respectively, that have led to a degree of "strategist consternation" according to BMO; "sure, the inflationary impulse from the Fed’s decisive policy action is difficult to ignore, but then why are breakevens effectively at the lows?" Lyngen asks, and notes that "There is little doubt that this facet of the last two weeks has been the most perplexing as investors grapple with the realities of a Covid-19 world."
What's going on here?
As Lyngen notes, "with 10- and 30-year yields back to levels not seen since late-February (before the coronavirus really took hold in the US), we’re left with only a few conceivable explanations for the divergence with risk assets and inflation expectations."
- First, uncertainty in a market experiencing liquidity strains. This isn’t the most satisfying answer to be sure, although the realities of constrained balance sheets on the part of the dealer community combined with a pullback from the electronic liquidity providers are impossible to ignore.
- Second, the rally which brought 10-year yields as low as 31.3 bp created a great deal of profits to be booked; therefore, realizing the upside may well have been the impetus for the initial backup which ultimately triggered accelerating momentum.
- Third, and closely related to the first two dynamics, the preference for cash versus any duration risk has led investors to liquidate the longer end of the curve in favor of bills – which have, not surprisingly, performed very well.
- Fourth, the Treasury Department is going to be ramping up issuance in a dramatic fashion to fund the fiscal stimulus efforts and to make up for the inevitable hit to tax receipts.
- Fifth, there was a surprisingly large amount corporate deals brought to market ($27.6 bn priced; largest single day in 2020 -- $10 bn of which was 20+ years) which were accompanied by rate-lock selling – again, into a limited liquidity Treasury market.
To this list we will only note that Breakevens tend to correlated very closely to the price of oil, which as we said last night has crashed to the lowest level in 17 years, and which at least on bank expects will trade with a negative (yes, really) price.
So in the event these explanations accurately encompass the underlying root of the weak performance of duration during the last week, then BMO believes that there will come a point at which the selling interest is exhausted and yields stabilize.
All else being equal, one might expect a period of comparative strength in 10s and 30s versus the front-end of the curve – especially in the context of continued price discovery in the equity market. The lasting impact on the curve shape (i.e. steeper) resulting from the recent price action remains to be seen, however the combination of ballooning Treasury issuance needs and the eventual return of inflationary ambitions bode well for the longevity of the move.
Meanwhile, having entered a trading environment in which flows are just as relevant as the fundamentals (or lack thereof), the technicals will reemerge as useful tools in gauging the extent any ongoing bearishness can run. In 10s, the 61.8% Fibonacci retracement of 1.159% represents support – particularly on a closing basis. Beyond there, is the 40-day moving-average at 1.337% with 1.25% as an obvious interim level. Momentum has extended in favor of higher rates and there is little sign of risking oversold conditions – at least not yet.
In conclusion, Lyngen believes that while it is tempting to interpret the bearish run in longer-end Treasuries as a signal the worst is behind us and cooler heads are prevailing, the truth is that it’s still too soon to assume that the low yield marks are in for the cycle, especially if the dislocation between yields and breakevens persists.
Rather, the choppy nature of the price action is far more consistent with an investor community unwilling to take a firm stand on the direction of the market at this stage. That may not happen until the Fed provides more staibility and/or guidance. Unless of course, it is the Fed's interventions that are now destabilizing the market by sending contrarian cross-asset signals. if that's the case, now may be a good time for traders to learn how to do something actually useful with their lives...