May 14

Bond Shorts Throw In The Towel

10 year yields are now down almost 10 basis points today as the benchmark US rate is now trading at 2.527%. The 2.60% -2.80% range that has been in place since early February has broken out decisively today with the all important 2.50% level in close view. Falling volatility in bond markets has been the main culprit of a bout of complacency across many asset classes. The beneficiaries of the rally in bonds have been high dividend stocks, emerging markets currencies, the Japanese Yen and short end treasury notes.

Many speculators came into the year with large short positions in US bond futures. Yields were expected to rise as the Federal Reserve wound down its quantitative easing program. Obviously this has not occurred, and today some players may be giving up for now. A friend that works on a buy side mortgage desk said plainly that some traders in his group think long end bonds are still cheap at 2.6%. This rationale is based on the fact that the economy is simply not doing well enough to warrant yields at these levels. There have also been op ed pieces out of the FT recently stating that what is occurring is a “sell the fact” scenario. The economy is bouncing back as the weather improved, but this was expected for the most part. These are all valid arguments in the context of economic growth driving sentiment on monetary policy.

However, I think that in recent weeks inflation (and housing) has risen to the top of list of excuses for Janet Yellen. The Fed plays somewhat of a game, using a multitude of different “problems” as reasoning(forward guidance) for continuing ultra easy policy. Right now that “problem” is that wages and inflation are low, too low to worry about tightening policy. Interestingly enough, there has been chatter this week about a significant acceleration in inflation. Producer prices came out today higher than expected at 2.1% year over year. Additionally, while wages on the headline number have looked stagnant, a look at production and non supervisory wages shows a clear uptrend. Since the headline wage number is masking this development, it makes sense to pay attention very closely to tomorrow’s inflation data. The turn in non supervisory wages started last summer, and the general rule is that it takes about six quarters for higher wages to feed into inflation.

noname                                                                                           Citi’s Steven Englander Sent This Chart To Clients Last Week


Now that all the economic fundamental talk is out of the way, you can forget it all for now. At the current moment, flows and sentiment seems to be trumping fundamentals. The bond market is doing well due to a range of factors, and none of them have much to do with the actual performance of the US economy. A combination of speculative short positioning, Chinese buying, ECB easing, geopolitical concerns, increased appetite for carry trades and low volumes have collided to create a situation where buyers far outstrip sellers in an environment where there is an increasingly small amount of long end bonds to go around that the Fed doesn’t own. On the sentient side, nobody seems to think the Fed should be more aggressive in tightening policy. The timing for the first rate hike has drifted out to August 2015. Markets had priced an April 2015 hike after Yellen’s “6 months” blunder at her first Fed press conference in March. Fed complacency seems to be seeping into rates markets cross the entire curve.

Last summer when bonds sold off the main source of pain for the bond market came from anyone holding mortgage assets. Massively large mortgage related accounts would pay swaps(sell bonds) on billions in DVo1, pushing up rates day after day as 10 year rates spiked from 1.6% to 3%. There were no material changes in the economy, but there were monumental shifts in the amount and source of flows.  These accounts came out to play because it was clear that volatility was about to rise. In recent months rates volatility has been dead, and a spark such as an inflation surprise will be needed to get volatility and volume to return.