The market has been pretty bearish on US bonds for some time now, a crowd that we have been firmly sat in. The bear case is clear; not only are major buyers on strike, some of them are actively winding their holdings down at a time when Treasury supply is set to explode. Add in a moderate pick up in the rate of inflation, fanned by fears that the Administration is piling on fiscal stimulus at the wrong end of the cycle, prompting greater monetary restraint from the Fed, and you have a fairly bearish cocktail, that’s for sure. But at what point is this all priced into the market?
For most of last week, bonds were acting bearishly with yields rising quite smartly. However, the action on Friday, was certainly not so bearish, leaving the question (for us at least) as to whether the character of the market is in the process of changing a bit. There are lots of ifs and buts here, and we’ll start with the front end of the market.
The current mid point for the Fed Funds rate is 1.625% (range of 1.5% to 1.75%) and the Fed is predicting they will raise rates twice more this year and three times in 2019. This would leave the Fed Funds rate at 2.125% at end 2018 and 2.875% at the end of 2019.
Currently, the market is ahead of the Fed for 2018, with Fed Funds Futures pricing in 2.30% and the OIS market 2.25%. However, the market is less aggressive than the Fed for 2019, with the Fed Funds Futures pricing in 2.75% and the OIS market 2.63%. Our view remains quite simple; the Fed will keep raising rates at each quarter end meeting until something starts to break. We don’t know when that something will start to break, but let’s say that the Fed raise rates three times over the course of the rest of the year and at the March and June 2019 meetings, taking the Fed Funds mid point to 2.875%, and at that point is done. (Implicit in this projection is that something starts to break in Q2 or Q3 next year and recession will be deemed to have started in the second half of 2019 – this is the setup for next week’s commentary, and all we will say is that beyond the start of the next recession, dangerous demons lurk).
With the 2 year and 5 year US Treasury yields currently sitting at 2.55% and 2.90% they are close to pricing in the peak in the interest rate cycle in terms of actual rate, if not timing. Chart 1 below plots the Fed Funds alongside both the two and five year US Treasury yields. If past is prologue, and in this case we think it is, then the two and five year Treasury yields will peak coincident with the last Fed rate hike, and in the same vicinity in terms of yield. So, if we are right that Fed Funds peak at 2.875%, then we are well on the way to that for the two year yield, and close to that for the 5 year yield. So, perhaps the upside momentum in shorter dated bonds will begin to diminish here before a lengthy topping process?
Chart 1 – Fed Funds with 2 and 5 year generic Treasury yields
If we shift the thinking further out the curve. Chart 2 shows the Fed Funds alongside the generic ten year Treasury yield, and in the lower panel we have plotted the shape of the yield curve as measured by the difference between the 10 year and 2 year Treasury bond yields. The picture of the 10 year yield peaking roughly coincident to the Fed Funds is also apparent here, but what is also apparent is that the yield curve inverts just before the last rate rise.
Chart 2 – Fed Funds and 10 year generic Treasury yield with 2s10s curve in the lower panel
So, let’s say that our view on the Fed Funds peaking at 2.875% is correct, then over the next few quarters, we would expect the two year yield to move higher by say 0.5% to 0.75%, the 5 year may nudge a little higher and the 10 year be roughly unchanged (this is assuming there is little in the way of interim volatility, which of course there will be). These yield changes would then lead to a flat or slightly inverted yield curve and that will be the sign that the Fed is almost done.
Now, of course many things can happen between now and next June. Inflation could rise faster, leaving the Fed scrambling a bit, thereby raising rates faster than predicted. This, we believe, would actually bring forward the recession. Perhaps the economy will continue to slog it out in the slow lane, and the Fed will raise rates more cautiously and elongate the cycle somewhat. For the time being, we remain committed to our view that the Fed will ultimately go too far, and create a policy error as the economy tilts into recession.
Complicating the picture somewhat is the fact that the Fed is also scaling back its balance sheet which adds to the amount of tightening occurring. Further complicating the picture is the recent tax cut and increased Government spending. Could these fiscal levers supercharge the economy forcing the Fed to tighten further and faster, or will they prove to be somewhat impotent? And of course, market events could easily overtake our thinking, especially if the troubles brewing in the emerging world begin to infect the broader system. All told, our view is that the US economy remains in the slow lane despite the fiscal stimulus and that the Fed will find that they have created a policy error at some point next year, if not sooner.
So, given the historical record that bond yields peak close to the last Fed rate hike, both in terms of timing and magnitude, and that we ae comfortable that the Fed will stop raising rates around 3% next year, is it really worth being too bearish on bonds when they yield 2.55%, 2.90% and 3.05% at the two, five and ten year majorities? We don’t think so. Does that mean we should rush out and buy today, expecting yields to stabilise or even decline? Well, we would think about nibbling away rather than rushing to buy.
The fundamental backdrop we believe is somewhat supportive. The economy has been growing more slowly in the current cycle than many would have expected, especially given the amount of monetary stimulus in place. We see the ageing baby boomers and their need for safe income as an ongoing source of demand for Treasuries. We see the record debt burden as ultimately deflationary. And from a cyclical perspective, with Oil over $70 on US WTI and around $80 on Brent, this is beginning to impact households potential for consumption growth. If oil is on its way to $100+ then this may accelerate the recession call, and it if declines from here, it will be supportive for bonds as inflation expectations drop. We would also note worrying signs in the Sub Prime auto loans market and other credit areas, but that is a subject best left for another commentary.
So, given our Fed Funds scenario painted above, and noting the supportive factors that seem to be in place, what about market pricing for bonds/yields and market positioning.
Chart 3 below plots the US ten year generic bond yield along with the 50 day moving average (blue). Although the trend since September is undeniably for higher yields, there is a bearish divergence developing between price and momentum. Also, as noted near the beginning, the price action on Friday was anything but bearish. We will be watching closely in the days ahead for signs that the yield is in the process of peaking.
Chart 3 – US 10 year bond yield with 50 day moving average and momentum in the lower panel
If the yield on bonds does begin to decline, and price rise, then a number of investors and traders are going to be at risk of being wrong footed. We suspect that most real money investors are underweight bonds and/or short duration. Furthermore, we know that speculators are near record short in both the five and ten year Treasury markets. Chart 4 below plots the price of the continuous 10 year Treasury future with the net positions held by speculative accounts.
As can be seen, net short positions have been pared back a little in the last three weeks even as price has dropped further; this in itself is creating a slight divergence that may be hinting at some sort of change ahead. Looking at the actual long and short positions in the lower panel, it can be seen that the small reduction in net short positions has been achieved by an increase in long positions held, not by shorts buying. This suggests that there is plenty of short covering potential if price were to start rising.
Chart 4 – US 10 year Treasury future with net positions held by speculators
When we look at the EuroDollars market, where speculators bet on future Fed policy, the situation is also interesting. Similar to the ten year, even as price has continued lower, net short positions held have declined modestly. This has been achieved by a reduction in short positions held, which is either a sign of simple profit taking after a great run, or perhaps big market players are beginning to sense that the Fed is relatively close to the peak in the interest rate cycle. We take this as an early sign that the market is taking a peak into H1 2019 and wondering whether the Fed Funds will peak then, which would then imply that recession risks are heightened moving into H2 2019.
Chart 5 – EuroDollars and net positions held by speculators
So where does that leave us on US bonds? We are beginning to shift away from our defensive position that we have maintained for a number of months. We recognise that there are risks in terms of a mini inflation spike in the second half of this year, which is why we are not getting more constructive at this juncture. We need to watch price developments in the next few weeks, but our preference is to look for buying opportunities rather than selling.
We also think that ultimately the yield curve will flatten and then invert ahead of the next recession, and so we will look for curve flattening trades. Last week, the 2s10s curve rose by over 10 basis points at one stage, and we think that it is these sorts of mini rallies that should be used to position for an inverted yield curve in H1 2019.
Of course, interest rates are the price of money, and so any change in yields that potentially wrong foots the market will have implications across all assets. We will try and cover these next week. So we will leave it here for now; we are looking at US yields perhaps being near a tradeable peak (price near a tradeable low), and perhaps yields will not move much higher in this cycle even though the Fed will continue to raise rates for the foreseeable future. We would also point out that with inflation in the 2%+ area, US Treasuries actually offer a positive real yield which is simply not on offer in Europe and Japan. Furthermore, US yields along the whole curve are now above the yield available from US equities. So, if there is value anywhere in Government bond land, perhaps it is in the US if you share our view that the Fed will stop raising rate next year as the economy tilts into recession.
Stewart Richardson
RMG Wealth Management
