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“We Could See a Sharp Jump in Long-Term Rates” – Janet Yellen

Rates jumped on Wednesday following a presentation by Fed Chair Janet Yellen in which she said “Long-term interest rates are at very low levels. We could see a sharp jump in long-term rates.” For someone that majored in ambiguity, this is a shockingly clear message.

Yellen then further set the stage for the movement higher in rates by reiterating that the Fed’s assessment is that risks to financial stability are moderate instead of elevated. She based this on the fact that they are NOT seeing:

1. Increase in leverage
2. Rapid expansion in credit
3. Substantial increase in maturity transformation (long term commitments funded by short term deposits)

In general, her comments suggest an absence of a bubble while also confirming the Fed’s commitment to remaining accommodative. In other words, “We’re going to keep rates low but not because we are scared of a bubble popping.” The combined effect was to encourage risk taking, which translates into dumping Treasurys and searching for yield elsewhere. Higher yields.

On the topic of Treasurys, she started off by noting that term premia are low (flat yield curve) but this can move dramatically in short order, such as the infamous May Taper Tantrum. “We need to be attentive to the possibility of these term premia moving up,” Yellen said, which is why the Fed is so focused on clearly communicating policy. Sometimes Fed-speak can have more of a tightening effect than an actual hike itself.

When the Fed Chair says rates could move sharply higher, markets listen. But the straw that broke the camel’s back was the German bund getting dumped as we walked in on Thursday. Two famous hedge fund managers called bunds the “short of a lifetime” and markets listened.

The yield at the start of the week was around 0.03%-0.06%. On Thursday morning, the 10yr Bund shot up to 0.80%. That’s not a misprint. Traders we spoke with were getting called in the middle of the night to come in to the desk. Panic was setting in for government bonds.

We’ve been describing the low Eurozone yields as a “leash” on US yields. The market has been largely keeping the spread between UST’s and German Bunds around 2.00%. As German yields move up or down (mostly down until last week), US yields follow suit to keep the spread the same.

Pension/insurance/hedge funds have trading algorithms that place buy/sell orders based on the spread to UST’s. As German yields took off, automatic sale orders were placed. The race up was underway…right up until another algorithm order was triggered that ordered the purchase of these same government bonds.

Markets were very jittery, but ultimately settled down. Throughout the wild swings, we kept noting to ourselves “nothing has actually changed in the economy, right?”

Then Friday brought the latest batch of job data. As you may recall, last month’s report was significantly weaker than expected. That put a lot of focus on Friday’s number. Were we seeing a weakening trend? Or was that last set of data simply a result of a nasty winter?

The market got its beloved Goldilocks number. The economy gained 223k jobs last month, right on top of expectations. It was a strong enough number to calm jitters about a slow Q1 but weak enough to keep June off the table for a hike. As markets reviewed the report, last month’s revision stuck out because the gains were only 85k, the weakest since June 2012.

The 10T settled in at 2.15%, well off the high of 2.31% but also well above the recent technical high of 1.99% from a week prior.

Europe is going to be driving the UST yields this week. Greece is a predictable mess, with that pesky €770mm loan payment due to the IMF from a previous round of bailouts. Tsiparis is stuck between a rock and a hard place, with his creditors refusing to budge and his diehard leftist backers rejecting any talks of austerity measures. His finance minister has said Greece can make the payment without an extension, but he has absolutely no credibility in the market. There is not a lot of optimism right now for a resolution by Tuesday.

Front End Rates and Cap Costs

Last week, we included a section on how clients with required caps should be preparing themselves for extreme price swings. “If you are buying a cap, brace yourself for extreme volatility and the likelihood that the price could jump dramatically in short order.” Apparently not everyone reads our newsletter because several cap buyers were stunned when cap prices swung by 20% during the week.

The Fed is data-dependent, which means each data release carries increasing significance because investors try to figure out if it means a higher/lower likelihood of a hike. This will translate into large swings in cap prices. This will be exacerbated around Fed meetings.

Get used to cap prices moving around quite a bit heading into a closing. These aren’t appraisals, costs move around as markets move. Don’t say we didn’t warn you.

The Pensford Letter – 5.11.15