“Yields: On the march!”, Jeff Gundlach tweet-shrieked, on Tuesday, before chiding the media for not paying enough attention to market action that essentially invalidated his “monumental” short squeeze pseudo-prediction.
“10’s above 3% again, this time without financial media concern”, he continued, adding that everyone should “watch 3.25% on 30’s [because] two closes above = game changer.”
If I had to sum up last week in rates and FX, I guess I’d just say that Jeff was surprised that nobody seemingly cared about the Treasury selloff and everybody else was surprised the dollar didn’t respond to yield rise.
Implicit in that admittedly oversimplified take is the notion that folks did not in fact ignore the latest bond selloff. Rather, everyone was just more focused on the dollar taking a breather. That’s because greenback weakness is more important from a near-term perspective to the extent it helps relieve some of the pressure on downtrodden emerging market assets and just generally loosens up global financial conditions. A weaker dollar also has the potential to give new life the global reflation story and you saw some of that last week in the commodities rally. Of course as Goldman notes, the causation works both ways – decreased appetite for Treasurys amid a risk rally is dollar negative.
There are some shades of late January/early February here when it comes to bonds. You’ve got a selloff and the average hourly earnings print that accompanies the next jobs report will be scrutinized heavily, coming as it does on the heels of the August number, which showed wages rising at the fastest annual pace since 2009.
A series of positive surprises on wage growth or maybe a couple of super-hot CPI prints could conceivably be trouble, to the extent that forces the market to reevaluate deeply- held convictions about the Fed.
“Our broad view is risk markets, including the markets for EM assets, can live with the Fed balance sheet reduction and rate increases that lie ahead for the remainder of the year on the condition that the pickup in both US wage growth and term risk premia in the UST market remain slow, and the market’s views on the neutral Funds rate is not shaken in a major way”, Credit Suisse wrote last week, before cautioning that “if that condition is violated, real yields across the US curve may rise sufficiently to cause a major problem for all risk assets, not least in EM space.”
For what it’s worth, the MOVE is nowhere near levels seen in May, let alone February.
The decomposition of the latest leg higher in 10Y yields betrays something of a break with recent precedent. As Bloomberg’s Tanvir Sandhu writes on Sunday, “the latest sell-off in rates is a function of an unwind of summer flight-to-quality premium rather than any major change in the inflation outlook, as real yields have led the rates sell-off from August lows: +21bp vs 27bp move in 10s and inflation breakevens only +6bp.” Here’s a visual on that, which not only illustrates Tanvir’s point about reals leading the march higher from the August lows, but also how last week, reals were steady while nominals widened:
And here’s breakevens over the same period, with last week boxed in purple to underscore the “break with recent precedent” point:
Is that a reflection of reflation “optimism”? Maybe not. Maybe it’s the term premium trade because, well, because look:
There are myriad other possibilities. Here’s Bloomberg’s Luke Kawa:
Perhaps it’s because foreigners are dumping U.S. debt. Indeed, China has been trimming its holdings. UBS has warned that escalating trade tensions might prompt the world’s second-largest economy to “fail to appear” at an auction or two, to send a message to the U.S.
Maybe it’s waning demand from pensions after advantageous tax treatment dissipated. But Wall Street doesn’t think that’s the case.
The pension fund story is interesting. To the extent demand wanes there, one could argue for a steepening bias, but as you’ll read below (and as Luke mentions above), attempting to make predictions about the shape of the curve based on the pension discussion could be a fool’s errand.
From a kind of 30,000 foot perspective, I suppose what you don’t want to happen (if you’re a U.S. equity bull, that is) is for the term premium to start getting rebuilt aggressively and/or for signs of inflation to start materializing at a clip that takes everyone off guard. If that were to conspire with less predictable/aggressively hawkish forward guidance, it could catalyze an uptick in rates vol.
“Delivered vol needs to see higher inflation, greater macro dispersion and changes in central bank communication”, the above-mentioned Tanvir Sandhu writes, in the same cited note.
There are too many embedded contingencies to get anything that even approximates a clean read on this, especially ahead of the Fed meeting. So, rather than try and extrapolate further, we’ll just leave you with some excerpts from a handful of recent analyst notes that together give you an idea of what Wall Street is thinking (and these are selected with an eye towards providing more color around the pension argument mentioned above).
Without much new information on US fundamentals in the past week, the recent moves tell us flow factors were the driving force, as positioning was cleaned going into September and sentiment on the rest of the world lifted somewhat. If yields continue to rise from here, we would start worrying about momentum traders. But for now, we think buyers can emerge, especially from the liability-driven community. We highlighted in the past that the pension fund story this year has primarily been a rates story –long end yields at YTD highs again will encourage further pension fund de-risking. As a result, our view of a grind higher and flatter in rates remains intact.
— BofAML, September 20
S&P 500 companies boosted their contributions to DB plans in 2017, and contributions for 2018 are expected to remain at a similarly high level. A number of public companies have mentioned corporate tax reform as a reason for accelerated pension plan contributions, supporting the view that this factor has boosted long-end duration demand if plans used the funding to buy these assets. [This] suggests that long-end duration demand could wane now that the tax deadline has passed.
However, we see a few reasons why the tax filing deadline is unlikely to be the primary driver of curve direction in the months ahead. First, despite the tax deadline, private DB duration demand should remain reasonably solid, in large part due to fund de-risking. Second, state and local DB plans have been accumulating fixed income assets, particularly Treasuries, at a steady clip.
While we see some evidence private defined benefit plans have been buying corporate debt and Treasuries, it is unclear how much buying was directly related to sponsors taking advantage of a larger tax deduction. It is quite possible we could see some curve steepening if the buying intensity subsides, but we would expect such a move to be temporary.
Overall, we believe that there could be about $400bn in combined purchases of longer-dated fixed income assets from public and private defined benefit plans over the next 5 years. Both of these inflows are likely to be gradual, but over time will weigh on the long end of the yield curve. The bottom line is we see the theory that a loss of contribution deadline-driven pension purchases will induce curve steepening to be overstated.
— Goldman, September 17
We remain strategically bearish on the market and maintain our aggressive bearish forecast driven my moderate additional scope for higher rates in the short-dated forwards, and by term premium recovery through the rest of 2018. Looking forward to this week’s Fed meeting, however, we are tactically reducing risk in the front end as we see a number of potential innovations from the Fed that markets might view as dovish for the rate trajectory.
As expected last week’s release of the Flow of Funds report from the Fed depicted robust pension demand for fixed income. Both corporate and state/local plans were sellers of equity. Given the significantly lower funding level of the public sector plans, we would interpret their equity sales and fixed income purchases as rebalancing. Corporate equity sales likely reflected some combination of rebalancing and de-risking, as the corporate sector in the aggregate is relatively closer to full funding of its liabilities.
The still open question is the extent to which corporate pension purchases stemmed from accelerated contributions deducted at last year’s tax rate, and before another increase in PBGC fees. We note that the peak and decline of the stripping data coincided with that of deal volumes in issuance intended to raise cash for contributions. We continue to argue that contributions and thus demand for were front loaded in H1 and hence demand on the margin will be declining during the balance of the year.
— Deutsche Bank, September 21