(Bloomberg View) -- What a difference a few days can make in the bond market. Last week, traders were using phrases such as "melt up," "short squeeze" and "capitulation" to describe the rally in Treasuries that sent yields to their lows of the year without any real change in the usual fundamental economic underpinnings that drive interest rates. This week, the euphoria has been replaced by a sense of loathing.
At the heart of the reversal in sentiment is the worry that the two traditional foes of bond traders -- inflation and supply -- are about to make a reappearance. Thursday's consumer price index data only reinforced those notions, as the cost of living accelerated following a five-month-long period of dormancy.
The report comes on top of the scenes of destruction from Hurricanes Harvey and Irma, with traders waking up to the realization that a massive wave of government spending is on the horizon as homes are rebuilt and infrastructure improved. The reconstruction will only exacerbate an already tight labor market, raising the odds of faster wage inflation looming after a long period of stability.
Yields on benchmark 10-year Treasuries fell as low as 2.01 percent, prompting many observers to declare that a drop below 2 percent was inevitable. Instead, they sit at 2.19 percent. Trading patterns suggest that if they were to break through the 2.20 percent level in a convincing manner, even more bulls would become bears. As it is, the market is pricing in about a 47 percent chance that the Federal Reserve raises interest rates one more time before year-end, compared with less than 25 percent last week.
This slump may be more than just a simple adjustment, judging by the Treasury Department's sale this week of three-, 10- and 30-year bonds. Every auction "tailed," meaning that yields came in higher than current market rates. That's not a sign of healthy demand, and should be worrisome for the Treasury given that none of the key players talking tax reform in Washington look to be favoring revenue-neutral proposals.
Treasury Secretary Steven Mnuchin suggested this week that lawmakers will count on a growth spurt to pay for the tax cuts. That budget-busting mentality -- once called "voodoo economics" -- will add large amounts to the Treasury's borrowing needs, which are due to soar anyway as the Fed stops reinvesting a portion of the proceeds from its maturing bond holdings into new securities.
With the debt ceiling issue being pushed back to December, and the Treasury's drop-dead date for avoiding default likely extended to at least March and possibly a lot longer, the decks have been cleared for a tax deal. The Trump administration has made it clear they will do it with Democratic help or without, using the reconciliation process to avoid a stalemate.
The Treasury market is rapidly shifting back towards the middle of this year's tight trading range, and the enthusiasm that made most everyone bullish on bonds is fading fast.
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.
To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net.
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