Bond Traders Are Too Election-Shy for a Yield Breakout
(Bloomberg Opinion) -- Heading into last Friday, there was no shortage of superlatives to describe the rise in long-term yields in the $20.4 trillion U.S. Treasury market. Just to name a few:
- The yield curve from five to 30 years steepened to 130 basis points, the widest gap since Nov. 16, 2016.
- The benchmark 10-year Treasury yield had climbed for six consecutive trading sessions, the longest stretch since September 2019.
- At 0.868%, the 10-year yield reached its highest level in more than four months and briefly broke above its 200-day moving average from below for the first time since late 2017.
- The yield curve from two to 10 years reached 70 basis points at the close, the steepest level since February 2018.
- Even 10-year U.S. real yields, while still deeply negative, increased to the highest since July.
This steady march higher in yields came in the face of wildly conflicting and ambiguous updates about the state of play of fiscal aid talks between Treasury Secretary Steven Mnuchin and House Speaker Nancy Pelosi, along with reports that Senate Majority Leader Mitch McConnell sought to get President Donald Trump to torpedo the negotiations entirely. Stocks whipsawed; bonds were resolute.
Then on Friday, just when it looked as if 10-year Treasuries were about to convincingly break through their 200-day moving average, something snapped. Yields reversed lower and the curve flattened without any obvious catalyst. Mnuchin said that Pelosi had “dug in” on stimulus talks and that significant differences remained, but that was hardly inconsistent with the back-and-forth from earlier in the week. And Mark Meadows, the White House chief of staff, said just a short time later he was still hopeful a deal could be reached “in the next day or so.”
The most likely reason for this retreat back into the range is that bond traders became nervous about extending themselves too far and riding a linear move with just a week and a half to go before U.S. elections. By now, it’s hardly a secret that the consensus “blue wave” trade in financial markets is for a “bear steepening” of the Treasury yield curve, with longer-term rates rising more than those at the short end. Investors expect that if Joe Biden wins the presidency and Democrats take a majority in the Senate and the House, that united government would usher in a huge round of fiscal stimulus that would boost economic growth and complement the Federal Reserve’s easy monetary policy.
Morgan Stanley analysts wrote last week that Treasuries still seem to be the least appropriately priced asset class in the event of a Democratic sweep. That puts bond traders in a difficult position. If all it will take is a smooth election to pave the way for 10-year yields to test 1%, as strategists at BMO Capital Markets suggest, then they should sell Treasuries now and potentially buy again once the dust settles after Nov. 3. But U.S. government debt is also bound to be one of the preferred havens if the election outcome remains uncertain or contested for days or weeks. To be sure, that’s not any more likely now than a week ago, with poll aggregator FiveThirtyEight’s election forecasting model giving Biden an 87.5% chance of winning the Electoral College as of Friday, compared with 87.1% on Oct. 16.
Still, the memory of the 2016 election won’t fade so quickly. On Nov. 8, 2016, 10-year yields plunged from 1.89% at 8 p.m. in New York to 1.72% just four hours later, with bond traders rapidly unwinding wagers that the Fed would raise interest rates, largely because of expectations of market volatility. Yet by the time the market closed the next day, the benchmark had jumped to 2.06% and would climb almost 50 basis points in the following weeks.
Imagine what would happen if bond traders went all-in on a Democratic sweep, sending Treasury yields soaring, only to see the Senate remain under Republican control. That would likely ensure at least two more years of gridlock and bring yields crashing back down. According to FiveThirtyEight, there’s a roughly 25% chance that happens — just slightly worse odds than Donald Trump had of winning the presidency in 2016.
It’s certainly possible that the polls will be more accurate this time around and that an across-the-board victory for Democrats leads to a sharp move higher in Treasury yields. But even then, investors have to weigh the prospect of the Fed fighting back against any sustained selloff that could make long-term borrowing costs too high for companies, homeowners and municipalities. Bloomberg News’s Liz Capo McCormick captured this phenomenon last week with an article titled “The Fed Has Trained Bond Traders Not to Push Yields Up Too Far.” Large trades in the options market suggest that, for now, traders have deemed 1% the central bank’s red line for 10-year Treasury notes.
I’m skeptical that the Fed would instantly move to curtail a rise in long-end yields if it happened because of a brighter outlook for economic growth and the potential for accelerated inflation. Chicago Fed President Charles Evans expressed doubts last week, saying that “we could try to do more on asset purchases, but I’m not quite sure how far we would get” in further lowering long-term interest rates. We’ll potentially get more clarity on its bond-buying plans soon enough — it’s hard to believe, but the central bank’s next decision is Nov. 5. If market volatility surges in the two days after the election, it’s anyone’s guess what Chair Jerome Powell might do.
Put it all together, and it’s hard to justify going out on a limb in Treasuries over the next week. But make no mistake, once all the ballots are cast and tallied, expect some fireworks in the world’s biggest bond market.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.
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