Monetary Policy & Inflation | Rates | US
I’m unsure where to begin to address the complacency lingering in the bond market. Is it a function of lazy longs that are enjoying the curve slide carry trades with the Fed perma-hold? Or is it disheartened bond bears recognising an uphill battle after seeing what the Fed can do when they step in with force? Either way, I feel that something is brewing in the bond market and that reports of its death have been greatly exaggerated.
10-Year Yields About to Breakout?
Let’s be honest. Macro insights and forecasting plays a big role in the formulation of trades and market views. But there is always the nagging pull of recent price action that can influence and result in recency bias.
Chart 1 is case in point, where I compare some simple statistics of US 10-year yields relative to some rolling historical levels. We can see that the last three months (63 business days) of price action has a strong influence on the next direction for rates. In other words, once rates start trending, they usually stay in that same trend. That has clearly been the case recently.
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Summary
- The recent 63 business days of price action has a strong influence on the direction of yields, where providing yields do not climb above their 63-day high the current trend will dominate.
- The recent testing of the rolling 63-day high yield print at a minimum means the long-term trend down from lower rates has stalled out. And/or that the risk is a snap back to higher rates ahead.
- Each time current US yields experience a sharp rally and approach long-term historical yield levels embedded in other bond markets for overseas investors, that too tends to create reversal in trend.
Market implication
- Medium-term, negative; US rates: Potential for a move towards 1% on the 10-year into year end.
I’m unsure where to begin to address the complacency lingering in the bond market. Is it a function of lazy longs that are enjoying the curve slide carry trades with the Fed perma-hold? Or is it disheartened bond bears recognising an uphill battle after seeing what the Fed can do when they step in with force? Either way, I feel that something is brewing in the bond market and that reports of its death have been greatly exaggerated.
10-Year Yields About to Breakout?
Let’s be honest. Macro insights and forecasting plays a big role in the formulation of trades and market views. But there is always the nagging pull of recent price action that can influence and result in recency bias.
Chart 1 is case in point, where I compare some simple statistics of US 10-year yields relative to some rolling historical levels. We can see that the last three months (63 business days) of price action has a strong influence on the next direction for rates. In other words, once rates start trending, they usually stay in that same trend. That has clearly been the case recently.
However, there are a few notable things I like to examine to see if the trend in yields is changing or about to change. One is the length of time that the current running yield stays underneath its rolling 63-day highest yield print. Two, when the 63-day highest yield print is tested by current yield levels turning up and going through it, that usually (but not always) signals that a new trend is occurring – or at a minimum the longer-term trend has broken.
As Chart 1 shows, we have been in a downtrend in yields since October 2018. That’s when Chair Powell committed one of his most famous policy errors by stating that Fed rate policy were ‘far from neutral’. That led to his about-face a couple of months later – now called the ‘Powell Pivot’. From October 2018 through this time last year, the 10-year rate consistently stayed under its 63-day rolling highest interest rate print by a wide margin.
The market has tried to test the 63-day rolling high print several times since. The first major attempts were in 4Q19. But those failed to result in a new trend and setup for the massive rally that occurred into and out of the Covid-19 shock in early 1Q20. There was one more try at creating a new high print and change in directionality in June of this year. That too failed.
After months of trading in a sideways range, the US 10-year yield looks poised to finally break out of this range in my view, and it somewhat resembles a repeat of what happened before the 2016 elections as well.
Will Japan and Foreign Investors End Up Trapped Longs Again?
In Chart 2 below, we look at monthly 10-year yields for the US versus Japan. Then we compare them with a long monthly moving average (MA).
Everyone knows that we have been in a global structural bull market for rates before the 1990s. But it’s interesting to compare the outright yield levels with the running averages to see how portfolio book yield has been influencing investment changes. For example, I have found that since the 1990s each time the US 10-year rallied sharply and touched the long-run MA level for JGB 10-year rates, it resulted in a reversal of the US rally.
Perhaps Japan, and foreign investors alike that have their own local built long-term bond portfolios, will not add to more belly-like USTs when US yields are near levels that their historical local portfolios have been yielding.
In 2016 the month-to-month closing US 10-year did not touch the long-run MA for JGB 10-year rates. But as historical TIC flows and Japan bank news documented, that period resulted in some investors becoming trapped longs on their UST holdings, especially post the election. Note the US 10-year once again spent the majority of this past summer around the long-run MA for JGB 10-year rates. If history is any guide, that usually ends poorly.
Conclusion
The market feels listless, but it’s exactly during these periods that new trends begin to develop. Although, we respect the power of Fed QE-related interventions, but given their balance-sheet policies are not clearly aiming at specific yield levels yet (with YCC on the backburner as they focus on market functioning), I feel the 10-year could climb to 1% or slightly higher before the Fed truly gets nervous about the impact on the economy. And if foreign investors liked US bonds at even lower yields, in theory they should love them if 10s were to backup to ~1%, providing further support.
In addition, both political parties in the US will likely want to introduce more fiscal stimulus as well as launch infrastructure spending post the election conclusion. Given that, it probably really doesn’t matter who wins the election because more bond supply is coming one way or the other. This should continue to exert upward pressure on yields into year-end.
George is a twenty years fixed income veteran. Over that time he has been an active participant on the research and investment side covering rates, structured products and credit. He worked both on the buy-side and sell-side. He can be reached here.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)
makes sense