The Bond Market Resets
(Bloomberg View) -- I have been emphasizing how important the charts have been to the bond market, which was stuck in a five-month-long trading range that broke very convincingly two weeks ago. That's when yields on 10-year U.S. Treasuries fell below 2.30 percent, forcing the bears to capitulate and reverse their short bets, fueling a rally that sent yields as low as 2.16 percent.
Now, that 2.30 percent level is back in focus after the selloff Monday after the first round of the French presidential elections on Sunday that failed to produce any surprises. The same chart-watchers whose black boxes told them to buy when the yield fell below 2.30 percent could now tell them to sell if it rises much above that level.
With the odds of victory of the far-right and euroskeptic candidate Marine Le Pen over the independent candidate Emmanuel Macron at a small but not insignificant 6-1, traders will shift the focus of their attention this week to more traditional drivers, such as the Treasury Department's auctions of $88 billion in two-, five- and seven-year notes starting Tuesday and continuing through Thursday, and the first-quarter gross domestic product data at the end of the week. Also this week, President Donald Trump is planning a series of announcements on health care and taxes that could affect the budget deficit, and therefore the future supply of U.S. Treasuries.
Speculative positioning is now far more balanced than in recent months -- and even years -- after the bears were forced to cover -- painfully, I might add -- their short positions in recent weeks amid the geopolitical crises and elevated risks in Syria, North Korea and France. That's largely why Treasuries had managed to stage a powerful rally, despite all the jawboning from Fed officials that they remain on track to boost interest rates three times this year.
Any one of these geopolitical risks in isolation might be manageable from the bears' standpoint, but the three in concert were too much too risk. In futures market, speculative short positions in 10-year notes plunged 90 percent; in five-year notes, they tumbled 80 percent; positioning in 30-year bonds went to near neutral. These were huge positional shifts, and the last leg of the rally brought in a new group of "fast money" players who saw the break of the key 2.30 percent resistance in 10-year yields as a technically significant trigger.
The U.S. economic data calendar has been sparse for a few weeks, but traders will finally get something to chew on late in the week with the release of reports on durable goods, trade, first-quarter GDP and the Employment Cost Index. None of these should have a dramatic effect on the Treasury market. For that, the market must wait for the monthly jobs report on May 5 and the consumer price index on May 12 after this month’s shocker of a weak inflation number added plenty of fuel to the short squeeze.
Although first-quarter growth data has disappointed, the Fed is unlikely to be swayed to delay rate increases by a repeat of the seasonal U.S. economic weakness. The bond-market bears have largely moved their short positions to the very front end of the yield curve via eurodollar futures. Those bets totaled 3.2 million contracts, a very large position.
The bears still see the Fed’s June meeting as a likely time for their fourth 25 basis-point rate hike of the cycle, particularly if the forecasts for a sharp rebound to GDP growth to 3 percent or more from the 1 percent estimated for the first quarter look more credible as the data filter in. The March hike was prefigured by an aggressive series of warnings from Fed speakers, and if this next live meeting in June follows that narrative, we should see central bankers get progressively more vocal about their plans by the end of May.
Those large shorts in eurodollars are counting on it, and their plans depend on a reversal in the inflation data. Another weak CPI report would drive the consensus on the Fed’s path to one more hike at most, and that one would be delayed until the September meeting. I would not expect things to get disorderly in the bond markets as there are still a lot of questions around the ultimate outcome of the French elections and the strength of the U.S. economy. But that doesn't mean there may not be more pain for bond traders. The market usually finds a way to expose positions, and there are new longs trapped below 2.30 percent for the first time in a while.
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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