While stocks appear to have regained their footing this morning, not to mention upward momentum, the big quandary in markets remain not stocks but bonds, which refuse to validate a stronger growth narrative just one day before the Fed is set to hike rates for the second time this year. In fact, despite a recent record short squeeze in rates, with net specs recently turning bullish on the TSY complex...
... bond bears just can't seem to catch a break as yields continue to drift ever lower while the yield curve pancakes.
So what breaks this unstable equilibrium? While the jury is still out, in his latest overnight note, Bloomberg's Mark Cudmore writes that Treasury bears "need to come up with something new" as they "haven’t come up with a compelling new argument in months, nor a reason why any of the old, stale logic will suddenly become valid now."
While Cudmore says he is not "particularly bullish" on TSYs, he notes that "if current yields are supposedly unsustainable, then all the evidence points to the fact that they need to come lower if anything."
And that remains a major problem for the Fed which tomorrow is set to push the short-end higher by another 25 bps. Should the 2s10s flatten by a similar amount, the market's verdict on the latest Fed decision will be a simple one: "policy error."
Belos is the full note from Bloomberg's Mark Cudmore
Treasury Bears Need to Come Up With Something New: Macro View
U.S. Treasury bears haven’t come up with a compelling new argument in months, nor a reason why any of the old, stale logic will suddenly become valid now.
I frequently hear that Treasury yields are unsustainable. On what basis? During the last five years, the average 10-year yield has been 2.16%, right by the 2.19% midpoint of the 1.32% to 3.05% range. Historical context would suggest that the current level of 2.21% is barely worth commenting upon.
“But the Fed is raising rates.” So what? Even after the expected hike on Wednesday, the spread between 10-year yields and the effective rate will still be more than 100bps. The gap has been much narrower for extended periods during the past 20 years. So that issue seems perfectly sustainable and not relevant.
“But the Fed is overlooking the risk that the tight labor market means wage inflation will feed through to consumer price inflation.” Is it? Perhaps the committee is just focusing on the facts.
Bond bears have been trying to preempt this danger for more than two years. The most recent average hourly earnings print showed the slowest rate of growth in more than a year. The U.S. labor market is healthy, but the participation rate remains very low and the rise of machines is providing a disinflationary force. Most importantly, we’re definitely not seeing the impact on CPI yet. It remains a theoretical risk, and a receding one based on the latest data.
“But the U.S.’s growing budget deficit will add to supply, thereby forcing up yields.” Will it? That correlation during the past 20 years has been poor but, if anything, it suggests that yields actually fall when the U.S. deficit widens. Also, the deficit was significantly more negative between 2009 and 2013, so this seems a spurious argument at best, and potentially contradictory. With central banks pumping so much liquidity into the system and purchasing so many bonds, there’s arguably a dearth of supply.
The Bloomberg Commodity Index closed Monday at the lowest level in more than a year, so input prices are providing another disinflationary force.
I’m not particularly bullish Treasuries –- I think the market offers only poor risk- reward opportunities compared with other assets –- but if current yields are supposedly unsustainable, then all the evidence points to the fact that they need to come lower if anything.