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Summary
- Since late March/early April, the 2-year US Treasury yield has traded in a ~4.6%/~5% range (currently 4.62%).
- We have preferred a buy-on-price-dips strategy since early April.
- A culmination of factors – US data surprises likely to become more positive, sticky inflation, and stretched technicals – means further short-end yield declines will be difficult.
Market Implications
- We still see additional downside in US short-end yields. But we take partial profit (50%) at current levels given the factors outlined above.
US Yields Have Been Choppy, But Trending Lower for 3 Months
On 11 April, when the US 2-year yield was trading very near 5%, we argued US yields, especially short end, were looking stretched to the upside. We wanted to fade the rise in yields by scaling into a received position in the short end.
We reiterated our buy-on-dips approach on 17 May, while highlighting the ~4.6%/~5.0% range in the 2-year US yield. Back then, we thought the US rates markets would remain rangebound, with a downward bias in yields. And this is the how price action has played out.
Lighten Up on Longs at Bottom of Range
Given we are at the bottom of the range identified in May, we think that further yield declines will be difficult.
Moreover, after this recent three-month run and, with big event risk from US CPI today, we would take partial profit on any longs.
There are three reasons, as my Macro Hive colleague Bilal Hafeez outlines, to think further yield declines will be harder to achieve in the near term.
1. Data Surprises Are Likely to Mean-Revert Higher
The US growth surprise index has been falling steadily since April (together with US yields).
Typically, US growth surprises show strong mean reverting properties, and the series has recently fallen below one standard deviation below its mean (Chart 2).
The odds are therefore high for a run of positive data surprises in the coming months. This supports markets pricing a more hawkish Fed, which will lead to a retracement higher for short-end yields.
2. Inflation Risks Remain
Today’s CPI print for June should tell us whether the low May print was a one-off or not.
Our model suggests an upside surprise for core CPI.
But even another low print may not be enough to shift Fed rhetoric. It has been clear that they need to see a phase of low prints to feel confident in easing.
After all, they got burnt extrapolating the low prints in late 2023 and were forced to revise away many of their Fed cuts for 2024 (Chart 3).
Finally, we cannot ignore that core services inflation remains at levels not consistent with Fed cuts (Chart 4).
3. Technicals Point to Short-End Yields Retracing Higher
Our technical report finds that RSIs in front-end contracts are moving closer to becoming overbought.
Meanwhile, a modest sell-off in rates could see investors return to selling rates – at least that is what our flow analysis would suggest.
Today’s CPI report provides an important event risk for our trade, but we are willing to position for an upside risk.
Meanwhile, the Fed has time to be patient rather than ramp up easing rhetoric.
Richard Jones writes about FX and rates markets for Macro Hive. He has traded and invested in interest rate and FX market portfolios spanning three decades, both on the buy-side and sell-side.