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10 Year Treasury – Is 3.05% the New Floor?

May 20, 2018

On April 23rd, our newsletter was entitled, “3.05% is the New 2.62%”.  It took a month to breach that new key technical level, but that’s exactly what happened last week.

Last Week This Morning

  • The 10T started the week at 2.97%, peaked at 3.126%, and closed out at 3.06%
    • German bund climbed from 0.56% to 0.64%
  • 2 year Treasury started at 2.54% and ended at 2.55%
  • LIBOR resumed its climb higher as we enter the 30 day window for the next FOMC meeting, resetting on Friday at 1.95%
  • SOFR ticked up to 1.74% and it will be interesting to see if it remains anchored there until the actual FOMC meeting (as opposed to LIBOR which starts moving higher ahead of the meeting as rate hike odds are priced in)

 

Treasury Yields

Welp, shoot, that didn’t take long.


Source: Bloomberg Finance, LP

That graph is a little scary because it doesn’t appear that there’s a lot standing in between 3.05% and 3.50%.  It also seems notable that the market didn’t puke over this movement.  It certainly feels like the market is ok with recent jump in yields.

In the near term, there are several reasons why the 10yr Treasury will struggle to run to 3.50%.

  1. Profit taking – the market has never been shorter 10yr rates than right now. It stands to reason some of those positions will be closed out to take profit off the table.
  • We are unlikely to see the sort of capitulation we saw a year ago. That was more about the market throwing in the towel on the Trump optimism (Obama care wasn’t repealed, tax reform had stalled out, etc).  The 40bps drop we experienced spring 2017 was a classic short squeeze, whereas profit taking is more likely going to keep a lid on rates rather than force a huge decline.

2. German Bund

  • If the bund climbs, the T10 will have room to move higher. But if the bund stays around 0.60%, it will be tough for the T10 to march dramatically higher.
    • Caveat – we think it’s going to keep climbing over the course of 2018, giving the T10 the rope it needs to keep climbing as well.
  • Here’s a graph of the spread between the T10 and bund illustrating we’re at the widest levels ever.

3. Emerging Markets

Whether we’re in the midst of a correction or the beginning of a massive downturn, the threat of a significant disruption (particularly the effect on currency or default of debt) should dampen rate movements.

4. Trade War/Tariffs

$200B in concessions…or maybe…

5. Dollar Strength

This one is actually tied to both the EM pain as well as the trade war with China.

As Trump was ramping up rhetoric about China manipulating its currency earlier this year, the PBOC (China’s central bank) cut reserve requirements by a 1.00%, effectively confirming what Trump was alleging.   Try to think of a move like this as if the central bank had just cut interest rates.

Because China’s rates dropped, US rates looked even better by comparison.  The yuan declined, and the dollar rallied.  This was precisely China’s goal – make their exports that much cheaper for us to buy.

But a rising US dollar has the impact of tightening financial conditions.  We saw this in the second half of 2015 when China devalued the yuan.  The USD jumped, conditions tightened, securitizations ground to a halt, etc.

Here’s a graph of the USD index over the last year.  The recent spike hasn’t tested new highs, but it has caused some short term pain in other areas like EM.

On a scale of 1-10, a spiking USD is about an 8 to the Fed.  It matters.  A lot.


Source: Bloomberg Finance, LP

Deutsche Bank derivatives head Aleksandar Kocic released a report last week on this very topic.

“An example is the 2015 episode where asset managers faced redemptions due to EM losses and had to sell the best performing assets (US equities) to cover those costs. This means more turbulence in developed markets and possible tightening of financial conditions, which could question the strength of the USD and possibly push Fed to take a pause.”

By now, most readers will be familiar with our tongue in cheek monetary policy cycle graph.  Kocic’s comments fall nicely in line with this cycle.

There is a key difference in today’s market – the market believes the Fed will keep hiking.  In fact, short positions on the front end of the curve are approaching all-time highs.

Therefore, unlike the last 2.5 years since the Fed first started hiking, the market expects the Fed to keep hiking.  A pause would catch the market offsides and could lead to a painful short covering correction.  Huge losses could be realized.  Volatility.  Etc.

Takeaway  – the market is in an oversold position and we would not be surprised if the T10 is range-bound for the time being.  We could see a run up to 3.25%, but 3.50% would be more challenging given the dampening effect of the items listed above.

Another key takeaway is that those all imply near term limits on rate movements.  There are too many factors present in 2018 to conclude rates won’t keep moving higher.

  • Global withdrawal of accommodation continues, led by the Fed’s balance sheet normalization
  • Oil
  • Hawkish Fed
  • Massive deficit will continue to force huge Treasury issuance.
    • Treasury issuance this week alone will include $99B in fixed rate bonds, the highest since 2010.
    • Budget deficit should top $1T in 2020
    • In a report last week, GS noted how the traditional relationship between the deficit and the unemployment rate has broken down recently

 

Goldman’s conclusion was that the US will have to continue issuing record amount of bonds to cover the deficit at the very same time the Fed is removing itself as a buyer from the market.

More supply.  Fewer buyers.  Higher yields needed to attract buyers.

“The sizeable demand boost provided by the recent deficit-increasing tax cuts and spending cap increases at a time when the economy is already somewhat beyond full employment is a striking departure from historical norms that is likely to contribute to further overheating this year and next and tighter monetary policy in response.”

Goldman concluded that the T10 will hit 3.60% next year, at which point the economy will start to feel the pain of higher rates.

That would coincide nicely with the FOMC hitting its new neutral rate of 2.50%-ish.

 

Bottom line – in the near term, there are several reasons for rates to not move dramatically higher; however, there are too many factors at play applying upward pressure to think the T10 is headed lower over the rest of the year.

Barring a shock, it would appear that 3.05% is the now the floor, not the ceiling.

 

This Week

Relatively quiet week on the data front, but there are a lot of Fed speeches planned, capped off by Powell on Friday.


Click to Open: The Pensford Letter PDF


 

Pensford