Having raised the specter of higher bond yields in recent months, we think that the market is showing signs that there may be some short term reprieve. If correct, and having said several times in recent months that higher yields could impact all financial markets, it would be churlish of us to not think that lower bond yields could usher in some improvement in equity sentiment as well.
Markets are a hard taskmaster, and with the talk of the 3% level being so important for the 10 year Treasury, perhaps this level will remain elusive for a while yet. Chart 1 below shows the generic 10 year bond yield over the last 6 months. The trend, as depicted by the moving average (in yellow) is still up, and therefore down in price, but momentum as shown in the lower panel looks to be turning lower.
Chart 1 – US 10 year generic yield
Speculators have been aggressively short the bond market again this year, but the last two weeks have seen net short positions cut back, coincident with the initial signs on yields topping. In the lower panel in chart two is the long and short positions held by speculators, and the red line shows that speculative accounts held record short positions until two weeks ago. It is these short positions that provide the potential fuel for a fall in yields and rise in bond prices.
Chart 2 – 10 year yield with speculative positioning
It’s not entirely clear to us what is helping bond markets in the last few days. Last week saw massive new supply from the US Treasury, a feature that will continue as the budget deficit increases markedly post tax cuts. Ordinarily, this new supply, especially with the Fed now reducing its balance sheet, would put upward pressure on yields. There has also been talk that Japanese investors (and perhaps the Bank of Japan!) will start buying more Treasuries. Perhaps yields just simply become attractive for yield starved investors? Whatever the forces, it’s not just US yields that look to be forming a top, it’s European yields as well, as seen in chart 3 below, which shoes the 10 year German yield moving below its own 21 day moving average and to the lowest yield in about the last four weeks.
Chart 3- German 10 year generic yield
Perhaps talk of synchronised global growth in recent months led to too much bearishness in bond markets. It is interesting to note that both the German IFO and European PMIs came in below expected. We are not trying to be economic bears here, what we are trying to point out is that global growth has been both reasonable synchronised in the last few quarters, but perhaps this is as good as it gets.
Chart 4 below shows both the IFO main Business Climate Index and the Expectations sub index. Both appear to be peaking around previous historically high readings and rolling over. Indeed, the expectations index often precedes turning points in the main index by a couple of months, and so it is interesting to note that not only did the sub index peak in November, but it is still heading lower.
Chart 4 – IFO Business Climate Index with Expectations Index
We do wonder whether the broad strength of the Euro is beginning to weigh a little on the heavily export dependent Eurozone. Certainly, we know that strength in the Euro has become a greater concern within the ECB. Maybe, just maybe, we are seeing the early signs that European growth is close to peaking (yes, at above trend growth rates). We need to watch these signs closely, but this would certainly give bond markets pause for thought about higher yields, not just in Europe, but also perhaps in the US, where yield differentials are at historically high levels.
So, it’s early days in calling for some sort of peak in bond yields, and to be clear, we would view any yield decline as more likely a consolidation within a trend to higher yields. But markets never move in a straight line, and we do think that bond sentiment may have become too bearish in the last few weeks, and so some sort of reprieve may well be seen.
Stewart Richardson
RMG Wealth Management
