Amid a flurry of geopolitical escalations, including a surprise breakout in hostilities between nuclear neighbors India and Pakistan, coupled with a barrage of potential "fat tail" developments including today's flurry of testimonies by Trump's former lawyer Michael Cohen, the second day of Fed Chair Powell's Humphrey Hawkins testimony in front of Maxine Waters and AOC, and Robert Lighthizer's China trade talks testimony, not to mention economic data that is going from bad to worse by the day, an eerie calm has once again fallen across markets, with volatility across currencies and equities continuing its downward trend.
But nowhere is the market's "comfortably numb" stupor more evident than in government bonds, where the market is pricing in virtually zero risk of any material moves as the MOVE index (which tracks 1m bond volatility) just a 28-year low, pointing to record complacency around treasury yields.
According to DB's Jim Reid, the catalyst for this renewed selling of vol is - drumroll - central banks. Commenting on Powell's Tuesday congressional testimony, Reid notes that "10y Treasuries traded in a range of just a few of basis points as Powell spoke, before ending the day down -2.5bps at 2.638%. We went back and looked at the range since Powell spoke in early January and found that on a closing basis, the range has been just 15.5bps which is the smallest since June last year, and the second smallest since October 2017."
And pointing to the chart above, which shows that the MOVE index is back down slightly above the all time lows (data back to 1988) "so central banks have killed vol again for now." Of course, a big part of this is the Fed's dovish reversal which has helped stocks jump over 14% off their Jan 3 levels while US HY spreads are -122bps tighter over the same period, having tightened -3bps yesterday.
Looking at today's 2nd part of Powell's testimony don't expect any material changes to the Fed's "patient" message unveiled at the start of the year:
the change in message has worked for markets in 2019 but there wasn't much more to give yesterday as it was mostly a repeat of the recent mantra in favour of patience before any further rate hikes are seen. Powell repeated that “our policy decisions will continue to be data dependent” and that “we’re in no rush to make a judgment about changes in policy.” So the Fed continues to be on the sidelines for now. Powell justified his position by citing “muted” inflation pressures and the fact that “growth has slowed in some major foreign economies, particularly China and Europe.” Finally, he also noted that “uncertainty is elevated around several unresolved government policy issues, including Brexit and ongoing trade negotiations.”
And yet, despite the Fed's best efforts to kill bond vol, Credit Suisse believes that the record love volatility belies the threat of a bond selloff, noting that "on five out of the six past occasions when the MOVE index has hit new lows, treasury yields have picked up over the next month."
CS also proposes several other reasons why yields are set for a sharp move higher (the bank's 12 month target is 3.1%):
- Negative term premium: The New York Fed’s model still points to a negative term premium. In our opinion, this seems wrong as investors should be rewarded for lending money for longer.
- Cyclicals imply higher yields: The ratio of cyclicals to defensives is implying slightly higher yields (this is a big change from the 2% yield it implied at the end of 2018).
- Bonds are mispricing the Fed. The change in bond yields and the change in the fed funds rate are closely correlated. CS economists believe that US rates will rise later this year yet the market is pricing in a higher probability of a rate cut than a rate hike in 2019 (a 14% chance of a cut versus a 2% chance of a hike).
- Inflation expectations are a little low. The 10-year breakeven in the US is at 1.9% (just above the average of the last 10 years at 1.8%). This is at a time when the oil price points to higher inflation expectations and wage growth is accelerating (3.2% on average hourly earnings and 3.1% on the private sector component of the ECI index and even with c1% productivity growth, core ULC should thus be rising above 2%). With employment growth set to be around 50bp above the rate of growth of the labour force, wage pressure should intensify.
- Funds flow: In 2019, the Swiss bank expects net supply for US treasuries will increase to $1trn at a time when foreign official buyers are increasingly buying fewer US treasuries. According to Zoltan Pozsar, a Credit Suisse economist, the new main marginal buyer of US treasuries is the foreign private sector but, in contrast to official foreign buyers, private buyers are very FX-sensitive and are unlikely to step up their buying due to FX hedging costs owing to the shape of the yield curve. Hence, we are likely to see either higher treasury yields or lower hedging costs.
- Long-term trend: Over the past 30 years, whenever 10-year bond yields have moved up to the upper end of their downtrend range, we have experienced financial or economic shocks. This time around, the 10-year bond yield seems to have broken its long-term trend but there appears to be no such economic or financial shock.
In short, if Credit Suisse is right, enjoy the record low treasury vol while you can (and can buy it cheap) - it won't last. And if and when MOVE moves higher (potentially in a rather explosive fashion), expect the spillover from any sharp repricing of volatility at this fulcrum asset class to hit all other assets promptly.