A statue of Albert Gallatin stands outside the Treasury building stands in Washington, D.C. (Photographer: Andrew Harrer/Bloomberg)

Treasuries' Day of Reckoning Shows Selloff Will Be a Grind

(Bloomberg) -- The Treasury market’s big bang came on a day that few traders could have seen coming. And that’s bad news for bond bulls in the days, weeks, and perhaps even months ahead.

In the grand scheme of things, nothing much happened to cause the benchmark 10-year U.S. yield to break through both its 2018 and 2014 highs in the span of minutes. Sure, Australia priced long bonds and investment-grade debt issuance showed signs of picking up. U.S. retail sales rose broadly last month, though some segments increased less than forecast.

Then again, there was no clear catalyst for the yield crossing the psychological 3 percent level last month, either. Rather than a smoking gun that sends Treasuries into a tailspin, it’s becoming clear that the underlying pressure of Federal Reserve rate hikes, swelling debt supply and accelerating inflation are weighing on the world’s biggest bond market and won’t go away anytime soon.

“The market was already trading vulnerable -- I think over the last week or so we’ve seen an inability to rally on ‘good’ news, and the longer we have hung around 3 percent, the more we have eroded the buying base,” said John Briggs, head of strategy for the Americas at NatWest Markets. “There is a real concern about funding deficits and supply with the Fed on the move.”

The U.S. 10-year yield rose to 3.093 percent on Tuesday, climbing the most in three months to surpass the intraday peak from Jan. 2, 2014, before stabilizing around 3.07% on Wednesday. Traders are now looking at the 3.2 percent area, which would match highs seen in mid-2011, just before S&P Global Ratings downgraded the U.S., prompting a flight-to-quality trade into Treasuries.

If the past few weeks are any indication, yields won’t test those 2011 highs so quickly. Asset managers have amassed an unprecedented net long position in 10-year Treasury futures, helping to partially offset what has been a persistent net short among hedge funds and other large speculators. It appears more shorts were added on Wednesday, as preliminary open interest for Treasury futures showed new positions surging across the yield curve.

In past instances of stretched positioning -- early 2017, for example -- speculators covered shorts as the market moved against them. As they shifted to net long, 10-year yields tumbled nearly 50 basis points in five weeks from mid-March to mid-April last year. Yet the group has barely budged this time, staying bearish as nearly every attempt at a rally proved fleeting.

“These are good levels for investors to add to their duration position,” Matthew Hornbach, global head of interest-rate strategy at Morgan Stanley, said in an interview on Bloomberg TV. “This is not a market that’s going to run away to 3.5, 3.75, 4 percent. We don’t see that happening because the level of inflation that we’re expecting just can’t get you there.”

Hornbach predicts that longer-term yields will eventually fall and the curve will ultimately invert. So do Ian Lyngen and Aaron Kohli at BMO Capital Markets. Yet they concede that “bearish price action must be respected,” and wouldn’t attempt to go long just yet.

Click here for a QuickTake on what comes next after 3%.

The yield curve from 2 to 10 years, in fact, has seemed to offer a strong signal for a selloff in the past month. It narrowed to about 41 basis points both in mid-April and toward the end of last week, before steepening sharply as the benchmark broke through key technical levels.

Dallas Fed President Robert Kaplan, speaking Tuesday, helped explain why. The central bank should lift rates gradually, and when it comes to deciding on three or four hikes in 2018, he said he’d “rather make that judgment later in the year,” and wants to avoid “knowingly” creating an inverted curve.

For now, bond traders are pricing in a more hawkish Fed, with the market-implied probability of three additional rate hikes this year now above 50 percent. That’s more than central bankers themselves have indicated in their “dot plot,” which they’ll update next month.

A single major catalyst can shake up the bond-market narrative, however. Ten-year yields in February looked destined to test 3 percent, before cracks in economic growth and turmoil in technology stocks forced the 10-year rate to tumble. U.S. equity markets fell broadly on Tuesday.

The move from 2 percent to 3 percent “was by and large a ‘good’ rise in interest rates,” said Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch, in an interview. “Now we’re going to see, via bank stocks, via emerging markets, via corporate bonds, whether 3 to 4 percent will be a ‘bad’ rise in interest rates.”

That tug-of-war will be with traders for a long time. So too will increased Treasury supply, given the federal budget deficit will exceed $1 trillion by 2020. And Kaplan said the Fed must decide over the next 18 months on going past the neutral rate, which to him is between 2.5 percent and 3 percent.

“It has been a slow grind,” said Jim Platz, a portfolio manager at American Century Investments. “Yields keep chopping upward, and we would anticipate that to continue.”

©2018 Bloomberg L.P.

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