US economy

US Treasury bonds — Raising the bar for real


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The patience of bond bears has been vindicated this week by much stronger than forecast US economic data. Having failed to sustain breaks above 3 per cent during the summer, the 10-year Treasury note yield has finally broken free, surging beyond 3.20 per cent today, a level not seen since 2011.

That kind of shift in this crucial benchmark yield that influences equities, US mortgage rates, corporate bonds and the dollar raises the bar for the monthly employment report due tomorrow. We need to see a very strong jobs number and some tasty wage gains to maintain this week’s bearish momentum in Treasury debt.

As it stands, the 10-year yield has risen a great deal more than its major rivals during 2018, having started January around 2.40 per cent. And before this week began, speculative net short positions in 10-year futures contracts hit a record, according to the most recent data from the Commodity Futures Trading Commission.

Keeping long-dated yields contained until the start of October was an array of global headwinds led by signs of slowing growth, particularly in China, and emerging market worries compounded by the threat of a trade war. 

So what has suddenly shifted the market?

This week’s tone in US data challenges the mood in some quarters that the tailwind from tax cuts was set to ebb in the coming months. We may well see the economy slow in 2019 — a prospect that rising yields (the US 30-year mortgage rate is nearing 4.75 per cent) and further strength in oil prices will help deliver. But now the risk of an extended US economic cycle is up for consideration and we can see this gaining traction by looking at what has driven the selling of Treasury paper — namely the real yield, a barometer of future growth and interest rate expectations for the economy. 

The 10-year real yield — reflecting the difference between a cash 10-year yield of 3.20 per cent and the 2.17 per cent break-even rate of inflation for the next decade — is above 1 per cent. That’s a lot of numbers to digest, but the real yield has not been over 1 per cent since early 2011 — a period when a certain former bond manager at Pimco turned negative on bonds only to see the market rally in price terms for the rest of the year.

Real yields have long been held down by quantitative easing and expectations of a slower long-term growth rate for the US economy. As the economy now appears hotter we also have the Federal Reserve allowing its balance sheet to wind down at faster pace.

So what we have here is a further repricing in benchmark yields as a stronger economy puts more pressure on the Fed to tighten and keep inflation near its 2 per cent target. The current overnight rate range of 2-2.25 per cent is too low if the economy is set for a higher growth path. That means the Fed’s current forecast of overnight rates plateauing at 3.4 per cent in 2020 and 2021 may arrive before then or perhaps go beyond that point for this cycle.

Hence why Jay Powell’s line this week that the central bank is “a long way” from raising interest rates to neutral has duly fanned the selling pressure in bonds. From the Fed’s perspective, the rise in real yields is good news as we are seeing a steeper yield curve. Not so long ago the talk was all about the risk of a yield curve inversion. A stronger economy that allows the Fed to raise rates should buoy cyclical sectors in the equity market.

Chris Iggo at Axa says the Fed is slowly becoming more hawkish and the data are currently a lot stronger than people thought:

“Interest rates at the moment are not high enough to slow down the economy.”

Plenty rides on how strong the jobs report arrives tomorrow. The bar is high for yields to rise further from here, but as we saw during 2013, and then just after the election of Donald Trump in late 2016, real yields play a very important role in bond market sell-offs.

Quick Hits — what’s on the market radar

  • I will begin with another US bond yield chart as this focuses on a very interesting development. Unlike the 10-year which has risen above its taper tantrum peak of 3 per cent, as you can see here, the 30-year bond yield is some way from hitting its 4 per cent high from that period. I suspect pension funds and other managers of long-term liabilities will like a further rise in long bond yields. And given the strong performance of the broad US equity market this year, laddering into long bonds and out of shares is the kind of rotation to watch out for.

  • The first Friday of the month: yes, it’s time for the latest US employment report, a monthly chunk of data that sets the tone for financial markets far and wide. Economists expect 184,000 new jobs to be created and a dip in the unemployment rate to 3.8 per cent for September. Wages are forecast to expand at 2.8 per cent, year-over-year, down from a 2.9 per cent pace in August. 

  • The rates team at BMO Capital Markets have looked at historic large beats in the ADP employment data to see to see if hefty upside surprises are more correlated with US non-farm payrolls: 

“The results show that even in those cases, 48 per cent instances resulted in a beat; in other words, still a statistical coin flip. As a result, there could be a sell-the-rumour, buy-the-fact in the offing as lofty standards can be hard to match, even in this economy.”

  • Equities across the board don’t like a sudden jump in yields, especially tech and other growth names. The NYSE Faangs index is under notable pressure. A stronger economy and a higher discount rate for cash flows means the growth premium for tech takes a hit. Michael Darda at MKM Partners notes: 

“Higher rates will tend to put pressure on valuations unless the expected rise in cash flows can offset the effect of higher discount rates.”

  • Rising bond yields and a stronger dollar means emerging markets face tightening financial conditions. The MSCI EM index dropped 2.7 per cent today, among its worst one-day slide this year.

  • One recent bright spot in EM has been Brazil ahead of Sunday’s presidential election. As the FT explains here, investors may be getting ahead of things. Brown Brothers Harriman notes:

“Markets are really running with the most recent Brazil poll numbers. After its recent outperformance, it just does not make sense to go long BRL near 3.85 [per cent] given such uncertainty, both domestically and globally.”

  • Italy and the bond vigilantes update: weaker prices for Italian government bonds erodes the value of the banking system’s €350bn holdings of such debt, notes BCA Research, who also calculate that the largest Italian banks have €160bn of equity capital against €130bn of net non-performing loans, implying a cushion of €30bn:

“Markets would start to worry about Italian banks’ mark-to-market solvency if their bond portfolios sustained a loss of €30bn. We estimate this equates to the 10-year BTP yield breaching and remaining above 4 per cent.’”

Your feedback

I’d love to hear from you. You can email me on michael.mackenzie@ft.com and follow me on Twitter at @michaellachlan.





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