‘The Main Story Here’

Two year US yields headed lower for a fifth consecutive session on Monday. The cumulative two-day decline looks to be on par with the largest such drops since 2008.

At one point, 10-year yields fell to 2.07%. Everyone is slashing their year-end targets, even if some desks think the rally has run too far. JPMorgan cut its end-2019 projection to 1.40% for 2-year yields, all the way down from 2.25%. Their 10-year forecast for year-end is now 1.75%. The call comes on the heels of the bank’s projection for a pair of Fed cuts this year, in September and December.

Two-year yields were lower by 8bp at one juncture Monday. 1.84 marked the lowest levels since December 2017.

If you ask Morgan Stanley, the road higher for yields will be challenging ahead of the July Fed, which the bank says very well might “witness the first rate cut in the easing cycle”. Credit Suisse expects a 25bps “insurance cut” next month.

“The sharp move lower in Treasury yields and the inversion of the 3m10y curve have raised recession concerns [and] increasing odds of a prolonged trade war are likely to have broader ramifications for global growth”, SocGen writes, in their own outlook piece. They too are slashing their year-end forecasts. “Against this backdrop, we lower our rate forecasts and expect 10yT yield to end the year at 2.10% and for the yield curve to steepen less than we had initially anticipated”, Subadra Rajappa said Thursday.

(SocGen)

On Monday morning, Nomura’s Charlie McElligott suggested the Fed may find it impossible to catch up to market expectations when it comes to how much easing gets priced in amid the trade war. The dynamics associated with the tariffs put the FOMC in a real bind.

If you ask Bloomberg’s Mark Cudmore, July may actually be too late for a cut. “US equities will slump after the June FOMC meeting if the Fed doesn’t either cut rates or signal that immense easing is coming [as] such easing is already factored in to front-end rates markets”, he wrote Monday, adding that “two-year yields are pricing the most future easing since March 2008.” The upshot is that if the Fed wants to deliver a dovish surprise, they need to cut this month. “With July becoming more likely than not, the June 19 meeting is in play”, Cudmore said.

“Monetary policy is the main story here“, Deutsche Bank’s Aleksandar Kocic remarked, in a client note making the rounds on Monday.

“On Friday, I was convinced that we were all going to be trading MXN vol for some time. Wrong.”, Kocic wrote, on the way to exclaiming that “the best performer was not even VIX, but short-tenor gamma!” Here’s the VIX on top of equity vol’s ratio to 1M2Y rates vol:

(Deutsche Bank)

Kocic continues, noting that “in the past, whenever we had a risk-off trade, VIX led the way (VIX up and so is its ratio to rates vol.” That is until now. Now, that ratio is down, where that means that while VIX may be rising, 1M2Y is outperforming.

Ultimately, Kocic reiterates his point from last month about the extent to which preemptive cuts would be a risky move considering the potential for the Fed to be viewed as complicit in the trade war. That complicity (if it takes the form of aggressive rate cuts) could embolden Trump further, prompting more tariffs, which in turn present upside risks to inflation and downside risks to growth, a situation for which there is no adequate monetary policy response.

“The most likely path of resolution is that the Fed would be reluctant to get dragged into being an accomplice in the tariff wars, which makes preemptive cuts unlikely, at least in an early stage”, Kocic goes on to write.

The implication (actually, it’s more than that – he says it explicitly) is that the economy would have to show concrete signs of faltering before the Fed would intervene. “In other words, things would have to get worse before [the] Fed jumps in”, Kocic says. “But when that happens, they would have to go big.”