A week doesn’t go by where a customer asks about diversifying their risk away from a concentrated list of hedge providers. “Hedge Provider XYZ has nearly all of our hedges, I wouldn’t mind someone doing business with some other providers.”
Yeah, us too. But I’ve seen this pattern a thousand times.
A C-Suite executive, let’s call him PJ, reads something about bank risk. His mind turns to counterparty risk. He inserts himself into the team’s process, demanding to know why the team’s allowed the company to become so exposed to a single entity. They have a fiduciary responsibility after all. And of course they’re willing to spend a little more to spread the risk around, that’s just prudent risk management.
Here’s the thing – we didn’t end up with a lot of hedges by accident. The lowest bidder won. Free markets and all.
We go and run the auction like we always do…then the same hedge provider is $20k cheaper…and suddenly PJ is less obsessed with risk diversification…"well, this deal is tight already…but on the next one…”. Then PJ goes back to other things and the team keeps buying the least expensive hedge.
Everyone wants Made in America…until it costs a few dollars more. We didn’t end up with a global supply chain by accident. It’s not like someone made a decision to manufacture in China because it was more expensive.
I will be interested to see how willing we are to buy American if it costs 50% more.
Last Week This Morning
- 10T: 4.51%
- 2T: 3.99%
- SOFR: 4.26%
- Term SOFR: 4.32%
- Trump threatens and then delays a 50% tariff on the the EU….maybe I need to threaten tariffs on my kids to get a return phone call?
- The House passed the one big beautiful bill that totally reworks our antiquated and needlessly complex tax code extends existing tax cuts…I’m not sure it’s going to breeze through the Senate where a lot of them aren’t up for reelection until the far side of ‘28
The Tail that Wags the Dog
When the Treasury auctions off bonds, a typical measure of demand is how closely to the existing yield the bonds get issued. If the bond is yielding 4.5% right before the auction, you would expect the newly issued bonds to get bought at a yield of 4.5%. Any delta is described as a “tail.”
US Treasury auctions are single price auctions (aka Dutch auctions). Bidders submit the lowest yield they would accept to buy. Once the auction is complete, the coupon and price are set and everyone gets done at the same price. If you submitted a bid for a yield of 4.45% and it gets done at 4.5%, you pay the lower price.
- Strong demand pulls the final coupon down and is a strong tail
- If demand exactly matches supply, the coupon will largely match the yield prior to the auction
- Weak demand pushes the final coupon up and is a weak tail
A normal tail either way might be 2-3bps. On Monday, the weak tail was 13bps. That’s incredibly rare.
That pushed the long bond to levels we saw briefly in October 2023 (Higher for Longer 1.0) and right before the GFC. Excluding that brief period in the fall of 2023, we are at levels that people under 40 have never seen before.
Japan was the Tim Apple of the week, with the 20yr gapping wider by 15bps. On a relative basis, this is a much bigger tail.
Japan’s 30yr bond broke 3% for the first time ever.
It wasn’t that long ago that Japan’s Yield Curve Control (YCC) kept its 10yr bond at 0%. First, Japan allowed the bond to float up to 1% and then officially ended all YCC in March of last year.
The Bank of Japan owns more than 50% of the Japanese bond market…and that might actually climb higher if it feels the need to intervene.
In case you’re wondering, the Fed owns about 15-18% of all US Treasurys. And yes, Treasurys is spelled that way – look it up.
It wasn’t just limited to the US and Japan.
For now, the long end’s erratic behavior hasn’t directly translated into similar reactions on the T10. Goldman’s Japanese rates strategist Bill Zu pointed out that 30yr relative vol has gapped wider to the 10yr.
Zu also notes that the 30yr movements are more technical than fundamental, “exacerbated by technical and positioning factors, including leveraged flattening positions and air pockets in long-end demand." In other words, the surge is more closely linked to macro trading strategies of major players than a sudden belief that Japan is going bk.
That being said, it’s hard not to look at the long end of the curve and not interpret it as a warning shot across the bow that could impact the parts of the curve we tend to care more about.
Inflation
We get the next Core PCE report this week, with consensus forecasts for 2.5% annual and 0.1% monthly. But since most economists expect Core PCE to climb from 2.5% to 3.5% over the rest of the year, Powell can file this under “What Could Have Been…”
We are particularly vulnerable to goods inflation shocks. This Bloomberg graph breaks down the individual components of the overall Core PCE reading.
- the rust-colored bars are “Services”…which currently make up 90% of total inflation
- meanwhile, “Goods” inflation is effectively 0%...which means a shock to that component should cause the headline number to jump
I disagree with the tariff strategy, but I do think the market is overlooking the revenue component of the tariffs. The tariffs have already brought in $29B more than the time last year1.
Unfortunately, the benefit of those receipts is likely to decline over time by offsetting policies from other countries as well as a drop in our demand.
The San Fran Fed does a great job of tracking demand vs supply contributions to inflation2. Demand side is the blue bars - I wonder how much demand may drop with uncertainty and higher prices.
Tariffs don’t happen in a vacuum, but those trends take far longer to emerge than it takes the media to create panic.
The Week Ahead
Lots of data and lots of Fed speeches packed into a holiday-shortened week, but tariffs will still dominate the headlines.
