Bond Market's Bulls Are Shaken, If Not Shattered
(Bloomberg View) -- There have been numerous sell-offs in the bond market the past five years, but each rout turned out to be short-lived as the market inevitably recovered thanks, in part, to central bank largesse. Now, however, there are strong reasons to believe this time may be different, and that the bond market's bears may finally be gaining control.
While the short end of the yield curve has been in a bear market for some time, with two-year Treasury note yields rising from less than 0.5 percent in June 2016 to 1.97 percent this week as the Federal Reserve raised interest rates five times, longer-maturity yields have largely traded in a tight range, or even fallen. But this week, the yield on the 10-year Treasury -- the global benchmark -- broke above the key 2.50 percent barrier.
The most successful trades of 2017 were bets on a flatter Treasury yield curve. Those positions got very crowded as the trend intensified, and now those are getting unwound rapidly this week. Those who look at the charts and trading patterns see further weakness in both the short and long term. It's safe to say the confidence of any remaining bulls looks to be shaken, if not yet completely shattered.
The main problem for the bond vigilantes in recent years was that the central bank quantitative easing vacuum never stopped sucking up all available fixed-income paper in the market. The combined balance sheet assets of the Fed, European Central Bank, Bank of Japan and Bank of England grew from 22.7 percent of their economies in 2012 to 37.5 percent at the end of last year, according to data compiled by Bloomberg.
This dynamic started to reverse in the U.S. in late 2017 as the Fed’s balance sheet tapering program kicked into gear, and now there are unmistakable signals from other central banks that the era of unlimited liquidity is ending. As central banks take away the punch bowl, it looks to some observers that the zero and sub-zero interest-rate party is going away as long-dormant inflation pressures show signs of building as the global economy gathers pace. The World Bank on Tuesday boosted its 2018 global economic-growth forecast to 3.1 percent from its prior estimate of 2.9 percent.
Given that the U.S. consumer was already feeling confident on the back of a low 4.1 percent unemployment rate, and corporate profits are rising at an impressive rate, every cylinder in the economic engine looks to be running smoothly. The only thing that has prevented the long end of the bond market from selling off sooner was those perplexing low inflation readings in 2017. But the Fed’s dogged confidence in the eventual return of inflation to its 2 percent target resulted in three rate hikes last year, with three more forecast in 2018. Bond traders are pricing in faster inflation on the back of a stronger economy and a surge in commodity prices.
All this doesn't help the U.S. Treasury Department, which is tasked with raising much more debt in the markets as the Fed withdraws and the Republican tax cuts drive deficits ever higher.
As if that wasn't enough, now comes the news that officials in China, the largest foreign owner of Treasuries, have recommended slowing or halting purchases of U.S. government debt. The Bank of Japan surprised investors Tuesday with a downward adjustment to its bond purchases, a reminder that the supply landscape is shifting in ways that undercut bondholders.
Although the U.S bond market is trending cheaper across all maturities, the sell-off has not been matched in magnitude by markets in Europe. It will be interesting to see if these new higher yields attract bargain hunters as the Treasury auctions $20 billion of 10-year notes Wednesday and $12 billion of 30-year bonds Thursday.
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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