Following the worst rout in years, Treasurys hardly budged on Friday in the face of two ostensibly large catalysts in the August payrolls report (which missed) and Jerome Powell’s remarks in Zurich (which were status quo).
Despite Thursday’s steep selloff in bond land, 10-year yields in the US are still hovering at just 1.56%, and most folks you care to consult suspect we haven’t seen the lows yet.
Indeed, UBS and BNP slashed their year-end forecast for benchmark US yields to just 1% this week.
To be sure, the macro backdrop seems consistent with the idea of the bond rally continuing. Although the services sector appears to be holding up fine in the US, ISM manufacturing is now in contraction and consumer sentiment is the worst of the Trump ear. Meanwhile, Germany’s manufacturing malaise continues unabated as industrial production and factory orders both came in worse than expectations.
If you ask Deutsche Bank, 10-year US yields haven’t yet “caught down”, so to speak, to the rest of the world’s reality.
In a note dated Friday, the bank’s Stuart Sparks builds on his discussion of the US rates market pricing in an outcome that sees the Fed being forced to cut aggressively, not because the domestic economy is necessarily falling apart, but rather because the economic divergence between the US and the rest of the world, along with a relatively hawkish FOMC, means the dollar is likely to remain buoyant, an outcome that risks the US importing disinflation at a time when policymakers are already struggling to hit their mandate.
“Market pricing for the Fed appears far more rational given risks not only of further trade deterioration and domestic recession, but also of importing a broad based decline in inflation rates across major economies that is unlikely to stem exclusively from slower growth”, Sparks writes in his latest. That, in turn, means that the “US rates market rationally is re-pricing given the evolution of risk variables outside the United States”, he continues.
The bank drives the point home with PCA. Specifically, they take quarterly changes in ex-US G7 10-year yields, derive the first three principal components and regress quarterly changes in benchmark US yields on the realizations of the first principal component derived from the non-US data, which ends up explaining 77% of the variance in US yields’ variability.
What does that mean? Well, it means that 10-year US yields are still too high.
As Sparks writes, “the US began to ‘overshoot’ the rest of the world during Q4 2016″ – so, in and around when Trump was elected. If US yields are to truly “catch down” to a level that’s in keeping with G7 data, 10-year Treasury yields would have to fall near 1.25%.
So, the bond rally is set to continue, right?
Probably, but this comes with a familiar caveat. Sparks notes that there are three “disruptors” which could break the spell, arrest the slide in yields and stop the bond rally in its tracks. Those three potential disruptors are:
- a trade deal that removes tariffs levied in the dispute thus far,
- a far more dovish Fed, or
- fiscal stimulus, most likely in Germany
In the same vein, Nomura’s Charlie McElligott noted Friday that “from a secular perspective, the only catalyst on the horizon to turn the tide of perpetually lower / negative rates would be widespread global pursuit of fiscal stimulus, in the potential form of US MMT”.