A persistent theme here at HR this week has been the emergence of two competing narratives on Treasurys. For those in need of a quick recap, see here:
- Trader: “Much More To Come” For Treasury Rally, Dollar Slump
- Why One Bank Is Still Bullish On Stocks (And Bearish On The Long End)
- One Bank Warns: “Markets Are Too Sanguine,” Fed Hikes Now More Likely
Essentially it comes down to this: do you think the outlook for global growth and inflation supports higher yields or do you not? And if you do, do you think it’s at least possible that your outlook, even if correct, could be undercut by a short squeeze because there’s a … ummm… let’s just call it 3-sigma… short in the belly of the curve that’s just waiting to be f*cked by huge rallies like we saw on Wednesday.
Well for their part, Deutsche Bank thinks real rates are a bubble. They even got the satisfaction of using that thesis to create a cute double entendre in the title:
“See, we have a sense of humor!” “Rates strategists are people too!”
Anyway, below find the rationale behind what will either prove to be a disastrously wrong or a spectacularly right call.
Via Deutsche Bank
At 2.5% the US 10y yield remains extremely low. In terms of its two components, breakeven inflation rates have almost completely normalized, but real rates at 30bps remain at levels comparable to those seen at the depths of the financial crisis.
We see real rates as extremely misvalued if not in a bubble. Real rates are far below (-2pp) levels implied by prevailing GDP growth rates, which have historically provided an anchor. Monetary policy has been the key driver of this divergence. If monetary policy had been set in keeping with its historical reaction function, prevailing growth and inflation would have policy rates at 3.5% today. Monetary policy has been set instead on a view of the future that embodies a break from the past: in the inflation-unemployment relationship; and in a long run slow down in productivity growth. But the inflation-unemployment relationship does not look to have changed. The Fed seems to be missing a key driver, the dollar, including which indicates no change in the responsiveness of inflation to unemployment. Nor does productivity growth look to have fallen below its historical trend in this cycle. Indeed we see the historical drivers of productivity aligning for an inflection up.
The key to a normalization of real rates is higher market expectations of the speed and eventual level to which the Fed will hike policy rates. Market expectations remain well below the Fed’s guidance. But this is typical, with past hiking cycles seeing significant repricings and average price losses on the 10y of -11% (at current duration 120bps on the 10y). The Fed simply sticking to its guidance should see market expectations move up, but this will take a few hikes and is more likely around the June meeting. We expect a more clearly apparent upward trajectory in core inflation later this year to make the Fed more anxious and reiterate or up its guidance. This is more likely around the September or December meetings. Our asset allocation remains underweight duration.