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.
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?