Tepid demand for Germany’s landmark, zero coupon 30-year bond sale on Wednesday raised questions about whether the bond rally – the vaunted “duration infatuation” – has finally run its course after an eye-popping rally in August which was really just the culmination of a rolling surge.
If Wednesday was a turning point (and it probably wasn’t given that precisely none of the macro factors pushing yields lower have changed and there are good reasons to believe the technical flows which turbocharged the rally at the long end in the US are still in play), nobody will blame bonds for taking a breather.
As Bloomberg’s Brian Chappatta wrote Wednesday while documenting the knock-on effect for corporate supply, it’s been a “crazy” ride. “The 30-year yield lurched lower by 8 basis points on August 1, then 13 basis points on August 5, then another 13 basis points on August 12 [and] after a one-day reprieve near its all-time low of 2.0882%, it cruised through that level, tumbling to as low as 1.914%”, he marveled, clearly still incredulous at the sheer scope of the rally.
Once 30-year yields fell below 2%, the Treasury department jumped at the opportunity to announce a new outreach campaign aimed at once again gauging demand for ultra-long issuance. In addition to having potentially unnerving longer-term implications for America’s debt management strategy, the decision to break the news on a Friday afternoon amid thin August liquidity was pretty clearly designed to try and engineer some curve steepening.
Given the ferocity of the rally, one could certainly take a contrarian view and suggest that when yields are falling so fast that the US Treasury is tempted to resort to what amounts to market timing, we might be in bubble territory. Perhaps – just perhaps – the “failed” German 30-year sale was the canary in the coal mine. One rates strategist who spoke to Bloomberg on Wednesday called it “an ominous sign for cash bonds” and BofA’s rates team last week drew a parallel with a lackluster 10-year auction that helped catalyze the 2015 bund tantrum.
Still, it’s difficult to escape the bevy of macro factors arguing for lower yields. The growth outlook is tenuous, at best. Inflation expectations have plunged. Commodities are grappling with the prospect of demand destruction tied to a global slowdown. And central banks are pot-committed to more easing, while the market is openly questioning their capacity to reflate. It’s a perfect storm for a bond rally.
That said, all “good” things must come to an end, and presumably the market has a breaking point. Maybe Germany’s “historic” sale was the straw that broke the camel’s back. Persistent rumors of a forthcoming fiscal stimulus push from Berlin also argue for, at the least, a pause in bund yields’ downward spiral.
One thing you should note is that, as detailed here on Tuesday, more than half of the bond rally and inversion in the US this month was explainable by reference to positioning and hedging activity in an environment of diminished liquidity – that is, not by reference to fundamentals.
According to estimates from JPMorgan’s rates strategists, 10-year yields in the US were as much as 25bp rich to fair value at the lows.
(JPMorgan)
As you can see there in the right pane, that translated directly into another leg of divergence between the recession probability signaled by the curve and that predicted by the data. In August, that disparity came courtesy of massive convexity hedging and HFTs pulling back as volatility spiked.
Read more: The Truth Behind Plunging Bond Yields
So, if Wednesday did mark a turning point beyond which the US long-end sells off meaningfully and in a sustained fashion, remember that in a certain sense, the August rally was never really “all there” in the first place, and the recession signal from the curve was something of a Fata Morgana – a false optic reminiscent of similar episodes in December and March.
If, on the other hand, the bond rally continues apace and US yields do in fact have a date with zero, forget we ever had this discussion, ok?
We certainly do live in interesting times!!
OK ! OK ! My take away is STILLl that irregardless of what everyone wants ( in a self interested sense ) there still winds up being a limit to the level of manipulation that can occur before finally the wheels fall off…..Yeah these surely are interesting times (vm)
There is risk in equities and debt! By one measure we are totally F’d!
In Search of Distress Risk in Emerging Markets (IMF April 20, 2019)
We find that, controlling for firm-specific variables and country fixed effects, the 5-year US Treasury rate, the Fed funds rate, and the VIX are correlated with distress risk:
See trouble brewing: https://fred.stlouisfed.org/graph/?g=oGbp
Also see, blind mystic, Baba Vanga, states: ” Donald Trump will fall ill with a mystery illness, leaving him deaf and suffering from brain trauma.”
This am, UST yields up to 1 yr and at 30 yr, down 2 yr through 10 yr.
Maybe the 30 yr zero coupon Bund was just too much duration for the market at that moment.
Or perhaps zero coupon bonds don’t meet some of the needs of the folks buying negative yield Bunds.
I admit to having a hard time grasping all the reasons people buy negative yielding bonds. I understand these include
– Financial institutions buying as regulatory reserves
– Institutions buying as repo collateral
– Insurers and pensions matching anticipated cash flows
– Investors combining negative yield bonds with FX swaps or other for positive carry
– Investors buying as directional bet on yield declines
– Central banks buying as monetary policy tool
– Investors buying as pure “mattress cash”
And I’m sure there are many more reasons I don’t have a clue about.
Would super long maturity zeroes meet most of these reasons as well as coupon-paying bonds or shorter maturity bonds?
Jyl, I think you covered the bulk of the reasons. The question I have is at what yield will investors of any stripe (institutional, financial, retail, etc.) just stop buying them (-1.0%, -1.5%?), whether at auction or or in the secondary market? And what will happen when those purchases stop?
So sorry, I gave wrong information in the first line above – or maybe it was right for the first few minutes of the market . . .
I’m kind of torn on this. I would definitely be betting on steepeners from here looking at the US in isolation. But when you include EU and the yield differentials, the picture gets murky, to say the least.