Congrats are in order for anyone who came into August convinced that the bond rally had (much) further to run, despite 10-year US yields having already fallen some 80bps in the first seven months of 2019.
When it was all said and done, US Treasurys posted their best monthly gain since the crisis in August, spurred along by the intensification of global growth fears, trade escalations, Brexit jitters and hedging flows into a thin market.
A benchmark index for US debt returned more than 3% for the month.
Gone is the “reflation” bump from Trump’s election (bottom pane in the visual below), replaced by expectations of slower growth domestically and the assumption that the factors which have supported the US long-end will persist unabated.
Term premia spillovers from abroad and the relative attractiveness of USD assets (hedging costs be damned) are generally seen as weighing perpetually on long-end US yields, and the attendant bull flattening pressure has inverted the 2s10s, exacerbating recession worries and prompting Steve Mnuchin’s Treasury to talk up the prospect of ultra-long issuance after 30-year yields fell below 2%.
The rally was turbocharged by a “forced” grab-in. JPMorgan on August 20 suggested that “fundamentals explain less than half of the move in interest rates and inversion of the yield curve in recent weeks”.
“Mortgage investors and banks are forced to chase a decline in yields, which we believe has rapidly created more than $500bn of demand”, the bank’s Josh Younger said.
That was itself exacerbated by thin liquidity and algos pulling back in the face of the spike in volatility. “This is all happening against a backdrop of very poor liquidity [as] market depth is much worse than a typical August”, JPMorgan’s Younger said, in a client call. That, the bank remarked, partially reflected “a pull-back from the high frequency market makers that dominate liquidity provision in Treasury markets”.
Clearly, there are no shortage of catalysts for a continuation of the rally. Between geopolitical turmoil (e.g., worsening protests in Hong Kong, Boris Johnson’s bold moves ahead of Brexit, Iran tension), a cloudy growth outlook and no end in sight to the trade war despite this week’s conciliatory rhetoric, episodic flights to safety seem like a foregone conclusion.
Still, some think the rally could stall – at least for a time. “Yields may enter a brief period of consolidation on diminished trade war intensity”, Goldman wrote Friday, recommending investors “play for yield consolidation by fading rate vol curve inversions”.
SocGen chimed in this week as well. “Rates volatility’s August seasonality lived up to its reputation, with the trade-war escalation fueling the biggest 1m rate rally in 30y swaps since August 2011 (European credit crisis)”, the bank remarked on Tuesday, adding that “while the magnitude of the rate rally has been impressive in its own right, the bull flattening of the rate curve is probably even more surprising given that it deviated sharply from the inverse rate/curve directionality previously observed”.
Looking ahead, all eyes will of course be on Jerome Powell in September. The Fed is laboring under withering pressure from the White House, as Donald Trump continues to demand aggressive action to bring down the dollar and Peter Navarro calls on policymakers to help alleviate the flattening pressure in the curve by cutting rates deeper and faster.
With no concrete signs that Germany is prepared to launch a full-on fiscal stimulus push (indeed, it’s not even clear there’s legislative scope for that even if the will was there) and China seemingly intent on focusing its stimulus measures inward, it’s difficult to see what could ignite a sustainable bond selloff. And besides, with positioning as stretched as it is, one has to be concerned that any sudden bear steepening would risk kicking off a tantrum, which could be even worse than a continuation of the rally.