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Can Bond Traders Snooze Through Trade-War Alarm?

Can Bond Traders Snooze Through Trade-War Alarm?

(Bloomberg Opinion) -- At least for a day, it looks as if bond markets have come to terms with the prospect of a prolonged U.S-China trade war. History suggests the panic might be short-lived. 

The benchmark 10-year Treasury yield tumbled more than 8 basis points to 2.3%, the lowest level since 2017, as investors flocked out of riskier assets and into havens. Why now? Maybe it was that economists at some of the biggest Wall Street banks are starting to treat a full-blown trade war more like a baseline rather than simply a risk. Or it could have been the eye-popping comment from a senior Chinese government researcher that China and the U.S. could be stuck in a cycle of “fighting and talking” until 2035. The Federal Reserve Bank of New York estimated that the new U.S. tariffs on Chinese goods would cost American consumers $831 a household annually. All the while, Thursday’s economic data was somewhat disappointing.

This lurch lower in yields comes at an interesting time for the $15.9 trillion Treasuries market because now is about the time in the calendar year when these sorts of moves tend to dissipate. In 2018, the 10-year Treasury yield closed between 2.8% and 3% every day from May 30 until Sept. 18. In 2017, the benchmark rate fluctuated between 2.1% and 2.4% from May 11 through Sept. 1. Effectively, between the U.S. holidays of Memorial Day and Labor Day — the bookends of summer — bond traders have coasted through a tight range.

Can Bond Traders Snooze Through Trade-War Alarm?

Even with the latest bout of trade-war jitters, another summer of range-bound trading may yet be in the cards. And it’s mostly because of the latest guidance from the Fed.

Minutes from the Federal Open Market Committee’s April 30-May 1 meeting reiterated that officials are in no hurry to raise or lower interest rates. Participants felt that “even if global economic and financial conditions continued to improve, a patient approach would likely remain warranted.” So, no rate hikes. Yet “participants continued to view inflation near the Committee’s symmetric 2% objective as the most likely outcome,” meaning no need to ease policy to juice price growth, either. I dubbed it an “aggressive pause,” meaning the Fed has entrenched itself at the current range of 2.25%-2.5% and has set a high hurdle for moving in either direction. 

With that in mind, it’s hard to envision the 10-year yield dropping much below 2.25%, even though it’s just 5 basis points away. But with seemingly no chance of future Fed interest-rate increases, it doesn’t make much sense for it to climb much higher than 2.5%, either. Betting on a tight 20-basis-point range of 2.3% to 2.5% in the months ahead seems reasonable. Or, to be a bit on the safer side, perhaps 2.2% to 2.6%. That upper bound is where Bank of America Corp. now sees the 10-year yield at the end of the year, lower than its previous estimate.

Expect more revisions like that. Economists have generally been slow to embrace these lower yield levels: The median forecast in a Bloomberg survey taken about two weeks ago calls for the 10-year yield to end September at 2.65% and gradually increase through the end of 2020. 

The biggest question, of course, is whether a trade impasse between the U.S. and China is enough for a Fed rate cut. As Bloomberg News’s Vincent Cignarella was quick to point out on Thursday, 10-year yields are below the 2.38% effective fed funds rate — an inversion that has preceded the last three recessions. Yet policy makers have looked past fleeting curve inversions before and may do so again as long as the economic data justify it.

Another outstanding question is to what extent any persistent market weakness will encourage President Donald Trump to strike a trade deal. It’s no secret he views equities as a referendum on his economic policies. The Fed, to some extent, also feels pressure to stabilize risk assets, judging by Chair Jerome Powell’s quick pivot in early January after the S&P 500 Index tumbled in the wake of the central bank’s December rate decision. There’s also this wild card to consider: that Trump won’t back down on trade and instead try to force the Fed to ease, as he suggested in a May 14 tweet.

As I’ve said before, in uncertain times, it’s never an outright bad idea to buy Treasuries, particularly the shorter-dated ones that led Thursday’s rally. But for bond traders who make a living on the moves of a few basis points, another summer of playing the ranges still isn’t out of the question. Already, there are some early signs of profit-taking, according to Bloomberg News’s Edward Bolingbroke. That makes sense give that the latest JPMorgan Chase & Co. Treasury client survey had shown the most long positions since November 2010. 

The Fed has made its stance abundantly clear. The trade war will most likely have plenty of twists and turns, both positive and negative, in the months ahead. And the U.S. economy remains largely on track. That context is critical when faced with a flood of bad news like the type that came out on Thursday. Until U.S. data take a sustained turn for the worse, or Fed officials cave to the pressure to ease, traders will likely balk at yields falling much lower.

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net

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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