Right, so on Tuesday, in the course of explaining why stretched positioning might not be a contrarian indicator for Treasurys (i.e., why the crowded spec short might not necessarily presage an imminent squeeze that ends up capping the rise in 10Y yields), Goldman reiterated their argument that the term premium has room to be rebuilt.
Specifically, the bank said this:
While the market has priced in more term premium in the successive sell-offs, we think that the path to normalization is still the uphill path. With the year-end forwards pricing 10-year Treasuries at about 3.0%, our forecast implies gains for duration shorts, and we see risks to our forecast as skewed to the upside.
That’s a reiteration of a long-standing argument. Goldman elaborated on it at length in an expansive note from May of 2017 and they’ve talked about it on numerous occasions since, most recently on April 20 when they wrote the following:
The secular decline, and cyclical variation, in long-term rates in recent years has largely been a term premium story. From January 2010 onwards, 10-year bond yields in the G-10 have on average fallen by about 240bp. Of that, term premium has accounted for about 200bp, with short-term rate expectations being broadly stable after falling sharply during the financial crisis. The rise in bond yields around the ‘taper tantrum’ reflected the re-pricing of term premia rather than short rate expectations. Over the course of 2017, despite three Fed funds hikes, term premia declined, driving the rally in long-term Treasury bonds as well as duration globally.
Well, if the term premium isn’t something you enjoy talking about, you should probably steel yourself, because this sometimes esoteric discussion is going to garner more and more attention going forward, especially considering the fiscal backdrop.
I talked at length about that on February 10 in “Release The Long End” and as I put it elsewhere overnight:
What happens when there’s actual price discovery for all of the new supply from Treasury issued to fund the tax cuts and the increased spending? The Fed is winding down the balance sheet, so private (think: price sensitive) investors will determine the clearing price and they will, sooner or later, begin to incorporate considerations about the long-term sustainability of America’s deteriorating fiscal position into their bids.
Speaking of things people said overnight on this point, Bloomberg’s Garfield Reynolds weighed in, listing the series of factors that have helped drive 10Y yields higher this week.
Of course the retail sales data on Tuesday was the main catalyst (see chart below), but Reynolds reminds you that this started earlier in the week across the pond with Villeroy.
“Much of the latest move that sent 10s above 3% has been seen as driven by technicals after being initially triggered by a jump in European yields,” Reynolds writes.
Recall that on Monday, Villeroy suggested that rate hikes will come “at least some quarters, but not years” following the official end of APP. That was probably meant to be a throwaway line and everyone probably knew that “quarters” was more likely than “years” when it comes to how long the ECB will wait after calling an official end to APP to hike, but explicitly stating it kicked off a series of big bund bets:
So that set the stage for Tuesday, when retail sales accelerated the declines in Treasurys.
In addition to jitters about what late-cycle fiscal stimulus is likely to mean for inflation when piled atop an economy running at (or at least near) full employment, the Fed is now forced to cope with soaring crude prices and as a reminder, breakevens have been following oil higher. As we’ve noted on too many occasions to count, that sets the stage for a self-feeding loop where inflation expectations follow crude higher, stoking rate hike bets which in turn drive up real rates which in turn weigh on risk assets and around we go.
The above-mentioned Garfield Reynolds touches on that on the way to mentioning the term premium debate. To wit:
That’s come as crude oil ratchets up in price, overwhelming such long-term bear factors as changing energy-usage profiles and U.S. shale oil production. While recent rallies benefited from unhealthy geopolitics, crude has stayed buoyant even as global tensions eased. That keeps bond traders edgy for signs of fresh inflation acceleration. It also helps explain why the term premium is back on the move — on pace for the steepest monthly jump since Trump’s November 2016 election. There’s plenty of scope for the term premium to keep going as the Fed moves to lessen its repressive sway over the market — ongoing balance sheet reduction, a Fed benchmark rate getting closer to inflation, and the growing chorus calling for an end to the dot plot. That all removes certainty, boosting the term premium and volatility.
Yes, “boosting the term premium and volatility”, a subject that was at the heart of a recent note from Deutsche Bank’s Dominic Konstam, who wrote the following on Sunday evening:
We think we have been moving into a new volatility regime versus last year, even though at face value volatility itself in rate space is still low, having fallen substantially from early-year local highs. One way to think about volatility is in the context of the term premium/risk neutral framework where curve regimes of bear steepening and bull flattening define a term premium driven vol regime and bull steepening and bear flattening define a risk neutral driven vol regime.
2018 suggests that we are closing in on the long run risk neutral rate as potential growth is not improving and then proportional changes in the Funds rate become much smaller.
As a result, the next phase of the rate cycle “should be” dominated by bear steepening and the normalization of term premium.
You get the idea. You’ll also note that the whole “well, eventually Treasurys will benefit from a safe-haven bid if shit really hits the fan” argument is undercut by some of the same self-feeding loops described briefly above and at length in some of our previous posts.
Rising short term rates and higher real yields combined with the short-term funding squeeze that played out in Q1 on the back of a series of technical factors have made cash appealing again, which in turn means, as we put it previously, “TINA is dead.” Recall this from BofAML:
The typical haven characteristic of Treasury debt is being hindered by the appealing rates of return on cash in the US. Historically during periods of market turbulence, money would flow from risky assets (such as stocks) into US Treasury bonds. But with $ Libor at 2.36%, support for Treasury debt is diminishing (consider that 5yr Treasury yields are 2.84%). In other words, the rise of “cash” as an asset class is altering the traditional allocation decisions of multi-asset investors in times of market stress.
Chart 5 highlights this point. We show the rolling 1yr correlation between total returns on 10yr Treasury bonds and the total returns on stocks (daily returns). We overlay this with the evolution of 3m $LIBOR.
As Reynolds concludes, “it all adds up to a reduction in the haven allure of Treasuries and increases the odds for an unusual overshoot to the top side for yields, one that can devastate a whole range of other assets.”
While “devastate” is probably a bit harsh, the overarching narrative makes sense and even if it didn’t, it doesn’t have to. That’s the thing about narratives – they become more true the more people believe in them.