Bond Market Stalemate Exposes Deep Divide on Outlook
(Bloomberg View) -- The lack of volatility in equity markets dominates the headlines, but a similar and just as important dynamic is being playing out in the $14 trillion market for U.S. Treasuries. Volatility in bonds seems to hit new lows daily, despite a series of significant global geopolitical shocks ranging from the U.S. election results to a steady stream of North Korean missile launches.
Analysts are split on exactly what the relentless decline in volatility will mean going forward, but perhaps it has something to do with recent economic data, which offer competing views of the likely Federal Reserve policy narrative and create a type of stalemate in the bond market.
For those focused on the health of the labor market, all is well after the 211,000 gain in nonfarm jobs last month confirmed that the U.S. employment engine continues to motor onward. Robust labor markets drive income and spending. The Fed believes the economy is very close to or at full employment, and the 4.4 percent unemployment rate has already dropped below the central bank’s long-term targets.
For this Fed, it’s all about “looking through,” as in looking through the weak 0.7 percent growth in first-quarter gross domestic product and expecting the familiar seasonal rebound in subsequent quarters to around 3 percent. That outcome would leave the Fed raising rates in June and September, with the possibility of another at year-end. Bond markets are pricing in about a 70 percent chance of a rate boost in June, though traders are not convinced another one will come before year-end. At the same time, the Fed is more actively preparing the market for the eventual shrinkage of its $4.5 trillion balance sheet, possibly by the end of this year.
Add in some higher budget deficit spending estimates and a possible tapering of quantitative easing by the European Central Bank and there you have the heart of the bond bear case.
For those more focused on inflation, the recent slowdown could derail the Fed’s carefully laid-out rate normalization narrative. The main bulwark of the bond bulls’ case rests in the very sluggish behavior of inflation in the last two consumer price index reports, which show core CPI running well below the Fed’s 2 percent target and, more importantly, seemingly headed downward. That’s before any deflationary fallout from China’s economic slowdown on the prices of commodities.
Underlying the bond-bullish view is the recognition that central banks around the world have created oceans of liquidity through zero or negative rate policies matched with massive debt monetization via epic QE programs, and that idle cash is still looking for yield. Note that very large speculative short positions betting on a slump in Treasuries has been wiped out in recent weeks.
What many traders call the “wall of cash” seems to temper every significant slump in Treasuries, and in recent weeks there has been renewed interest in U.S. government debt from investors in foreign markets where yields remain far below what they can get in America. It may seem ridiculous to a casual observer that a 10-year Treasury note yielding 2.35 percent would be viewed as a high-yielding instrument, but when compared with the 0.44 percent offered on German 10-year bunds it begins to make more sense.
Also, the lower volatility gets, the more investors will look to add corporate and mortgage bonds. I would expect that to last until at least until Fed policy makers meet on June 14.
The bond market has plenty of fans for each of the two opposing viewpoints, which means this extended stalemate in Treasuries is likely to last.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Scott Dorf is a managing director at Amherst Pierpont Securities. He has been selling and trading U.S. Treasuries for more than 30 years.
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