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In a Flash, Flynn Takes Bond Traders' Eyes Off Tax Bill and Fed

(Bloomberg) -- Within a span of minutes Friday, bond traders had to put on the back burner just about everything they were focused on heading into the home stretch of 2017.

Deliberations over how many times the Federal Reserve will tighten next year, and price swings as a succession of Republican senators jumped on board the GOP tax plan suddenly seemed irrelevant for the Treasury market. Much like in May, when contents of a memo written by James Comey surfaced, U.S. political turmoil sent financial markets into a risk-off frenzy.

The benchmark 10-year yield plunged almost 10 basis points on news that former national security adviser Michael Flynn pleaded guilty to lying to federal agents and is cooperating with Special Counsel Robert Mueller. Now at 2.36 percent, the yield is once again below the 2.4 percent mark that’s proven a key technical area for months. It poked above that level Thursday and Friday amid bets that a tax overhaul would get through Congress, potentially spurring the Fed to ramp up the pace of rate hikes.

“When the rules change, you put your hands in your pockets until you can figure things out,” said Glen Capelo, head of rates at Academy Securities. “This does obviously put taxes on the back burner. Whether the GOP continues to push it through will be the question of the day for now, and of course the Fed.”

Moving Ahead

Signs still point to the tax plan moving ahead. Senate Majority Leader Mitch McConnell said Republicans have the numbers to pass their bill. A vote may come Friday or early Saturday, according to White House Legislative Affairs Director Marc Short.

That progress could have significant implications for the Treasury market. Bob Michele, who oversees about $483 billion as head of global fixed income, currency, and commodities at J.P. Morgan Asset Management, said Friday that the Fed could raise rates more than four times in 2018 if a tax overhaul becomes law.

The market is already shifting toward the Fed’s outlook. Traders are moving closer to three rate hikes between now and year-end 2018, according to fed funds futures data. A month ago, they were barely factoring in two increases over that period.

And for all the market volatility around the Flynn news, the two-year yield, the coupon maturity that’s most sensitive to Fed policy, was the least affected, falling about 1 basis point.

Whether Friday’s Treasury rally was a flash in the pan or something more substantial likely won’t be known until next week. That’s when traders get a slew of crucial U.S. data, starting with factory and durable goods orders and ending with November’s jobs report. Should those gauges come in strong, the 10-year yield may again test the 2.4 percent level that some bond managers have called “the moment of truth” for the three-decade bull market.

But after Flynn’s plea deal, that moment will have to wait.

©2017 Bloomberg L.P.

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