Dazed and Confused?

The bond market might be taking this into account for in spite of the strong jobs data and rebound in manufacturing, yields of long-dated U.S. treasuries refuse to trend higher. However, there are other forces holding down long-term UST yields.

There is confusion regarding the bond market, the shape of the UST yield curve and the way UST yields have behaved. This confusion has materialized even among fixed income professionals.

A Wall Street Journal article, published last week, discussed the potential for continued bond market volatility. I was taken aback by some of the responses by fixed income market professionals interviewed for the article. One bond market participant told the WSJ:

“It is hard to figure out what is really going on with the disconnect between data and the bond market.”

Is there really a disconnect? When the tremendous demand for bonds from aging demographics around the world, a sovereign debt arbitrage which is occurring (see the 0.15% 10-year DBR and the -0.04% 10-year JGB) and that dataset correlations appear to have changed (due mainly to technology and globalization) are considered, low long-term rates are not all that surprising.

Another comment was somewhat more troubling, at least for me. A fixed income market participant told the Journal that movements in long-dated Treasury yields “are increasingly disconnected from short-maturity yield movements.” The truth is that the long and short ends of the yield curve often disconnect when the Fed is tightening or threatening to tighten. The same is true for easing, by the way.

2-year to 10-year UST Benchmark yield curve spread (Lower = flatter) (Source: Bloomberg):

The circles represent times when the Fed moved to a tightening/renormalization bias. Each time, the yield curve flattened. This is logical. As the Fed tightens, it makes the cost of capital more expensive. This makes lending to consumers more expensive which usually cuts down on consumer spending, which is disinflationary. Since long rates always move on inflation pressures/expectations (not growth, this is proved in the late 1970s/early 1980s when inflation and growth diverged), the yield curve flattens when the Fed tightens or is leaning in that direction. The curve flattens more dramatically later in a tightening cycle. That it flattens at the mere whisper of tightening is the bond market’s way of telling you that the economy/inflation pressures are not strong enough to take much tightening. That most fixed income strategists, including myself, do not believe that the Fed Funds Rate peaks higher than the mid-2.00%s (if that) during this tightening cycle (if it can truly be called that) indicates that the bond market is probably not “wrong.” It rarely is.

Readers should remember I wrote the following prior to Ms. Yellen’s speech last Tuesday:

When Fed officials speak hawkishly, the retail side of the business reacts by assuming that all interest rates will rise. However, the bond market reacts by flattening the yield curve. This happens either by long rates staying put/trending lower, or rising less than short-term rates. When this happens, media pundits and those on the retail side of the business ask what the bond market sees or simply says; the bond market is wrong.

First, the bond market is not wrong. Secondly, the yield curve almost always flattens when the Fed is tightening or threatens to do so. A flattening curve with short-term rates rising and long term rates changing little or declining usually occurs late in the interest rate/economic cycle. The trend for more than a year has been for a flattening UST yield curve. The trend since December 2015, when the Fed tightened for the first time in nearly a decade, has been for higher short-term rates and lower long-term rates. The bond market is clearly flashing a late cycle warning.

This again proves my point: Fed tightening=flatter curve. Fed easing=steeper curve. Yes, it really is that simple. However, the investment business (and financial media) has been dumbed-down to the point that interest rates are viewed as a single entity. This is a dull-witted way of viewing interest rates. Yet, because this view is easy to explain to investors (and therefore sell products and models), this line of thinking prevails.

How the yield curve responds to monetary policy and how interest rate (and currency) arbitrage impacts U.S. Treasuries is “Bond Market 101.” I don’t expect investors and financial advisors to possess this knowledge, but I do expect bond market professionals to have it. Maybe the bond vigilantes are back, but instead of pushing long rates higher, they are pushing them down. Remember, if you are the bond market, you can intimidate anyone. (5) (6) (7)

Amazing

Since the Fed has softened its tightening stance, I have heard comments implying that the Fed is helping the ECB and BOJ by not allowing monetary policy to diverge too far. One pundit offered the possibility that there may have been a behind the scenes agreement at the last G20 meeting in which the Fed agreed to combat monetary policy divergence. As Casey Stengel once asked while managing the neophyte 1962 New York Mets: "Can't anybody here play this game?"

Successful or not, a main objective of negative interest rate policy is to devalue one’s currency. This is to help boost corporate profits by increasing exports and to help counter deflationary/disinflationary trends. Thus, the BOJ and the ECB want currency divergence, at least with the United States. On the other hand, The Fed is probably concerned that the stronger dollar during the past two years (due to monetary policy divergence) is crimping U.S. exports and weighing heavily on corporate profits, thereby retraining U.S. GDP. Thus, if the Fed hints at reducing monetary policy divergence, it has the potential to weaken the USD and hamper the efforts of the ECB and BOJ to reinvigorate their economies and generate some inflation. Rather than thanking Fed Chair Yellen for speaking in more dovish tones, ECB president, Draghi and BOJ president, Kuroda are probably muttering unkind words under their breath. A chart of the DXY USD index since last Tuesday bears this out:

USD DXY Index versus major foreign currencies (Source: Bloomberg):

Debates rage in the capital markets over whether long-term rates can remain low and whether the USD will continue to exhibit weakness. I cannot say for certain whether the U.S. dollar will strengthen or weaken from here, but I am reasonably certain that the BOJ and ECB will do their best to keep the USD from weakening much more. This could involve purchasing more U.S. Treasuries. This could be why long-term U.S. yields are falling. Institutions have been better buyers of U.S. Treasuries in recent weeks. Maybe they are trying to get ahead of the European Central Bank and the Bank of Japan. The talk in the interest rate markets last week was that European investors were in buying Treasuries following Ms. Yellen’s speech, last Tuesday.

The way I see it; long U.S. interest rates have limited upside potential and the USD has limited downside potential until there is meaningful and sustainable turnaround in Japan and the EMU. Until that happens, the Fed is unlikely to become more hawkish unless of course inflation pressures build, from either a weaker U.S. dollar or wage growth-led consumption. Neither looks especially threatening at present. Moderate and steady appears to be the course which the U.S. economy is on.

The Fed Funds Futures market is not pricing in a pickup in the pace of Fed tightening. The market does not see the Fed Funds Rate topping 1.00% until March 2019.