This commentary originally appeared on Real Money Pro at 12:00 p.m. on Jan. 13. Click here to learn about this dynamic market information service for active traders.
The bond market has quietly had a good run the last four weeks. After 10-year Treasury rates topped out at 2.6% on Dec. 15, rates have fallen 25 basis points, returning a little more than 2% for investors. Meanwhile, corporate credit is on fire, and are foreigners dumping our bonds? Here are some quick hits on what might be coming next.
Treasuries sit at an important technical level
A few days ago, legendary bond investor Bill Gross said that if the 10-year Treasury went above 2.6%, we were in for another leg of the bond bear market. Perhaps. But to my eyes, 2.35% is really the key level, and that's right where we sit now. This is the third time in the last six weeks that rates have rallied to this point. Each time, they have sold back off.
My gut is that we're a little more likely to see rates a bit higher than lower in the immediate term. The Trumpflation narrative isn't going to be broken until something happens to break it. By mid-December, the short base had become enormous in Treasury bonds. I think we saw some value-based buying come and that probably smoked out some weak-handed shorts. Repo data suggests the short base has been alleviated (although still probably elevated). And while value is OK here at 2.35%, it certainly isn't obviously cheap if the Fed is going to hike three times in 2017 and three more times in 2018.
Could the Trumpflation narrative fall apart? Sure, but it probably takes either Trump failing to create the fiscal stimulus everyone expects or that stimulus doesn't have the anticipated growth effect. Neither of those will be obviously the case for several months, if not a year or more. We could get some exogenous event, too, but you can't bet on that. So I expect rates to either hang around here or be mildly higher until either there are signs of stronger inflation or weaker earnings.
For what it's worth, if we were to break 2.35%, the chart looks like we'd have to fill in a gap to 2.22%. I suppose that's possible, but I'd probably be a seller there. In theory, the next gap is all the way to 1.85%. That isn't going to happen unless we get some sort of severe exogenous effect.
Corporate credit is on fire
High-yield credit spreads are approaching 2014 lows and are at the eighth percentile since 2010. Demand at new issue is red hot, with deals now coming at negative concessions. That means people are actually paying more to buy a new issue than secondary bonds. That only happens when bonds are so hard to buy that just the opportunity to buy a large block at new issue is worth overpaying for.
I warn readers, though, that this setup could be very much like 2005-06. At that time, the economy was humming and the Fed was slowly hiking rates. Higher absolute rates made corporate bonds attractive, and decent economic growth meant that defaults were low. This could definitely repeat now, resulting in persistently tight spreads. In such a world, even buying high-yield at tight levels will wind up making you money on income generation. I wouldn't expect much price appreciation, but I think someone who wants to buy and hold for a while will do fine.
Speaking of a red-hot market, I wrote on Twitter (@tdgraff) a bit about a huge controversy over covenants that is brewing in the corporate market. This gets a little bond-geeky, so I won't go into a ton of detail here. The short version is that companies are trying to insert language that basically leaves no penalty for intentionally violating certain covenants. Some investors caught on and there was a mini-revolt, causing some big issuers to pull the offending language from pending deals, including General Motors (GM) and Broadcom (AVGO) . Call it a win for the good guys, but I am not hopeful about the long term. Covenants have been in decline for my entire career. We haven't heard the end of this.
Are foreigners dumping our bonds?
I keep seeing articles claiming that foreign "dumping" of Treasuries is the next big threat to U.S. rates. Most of these stories are reading the situation backward.
This week the Treasury auctioned three-, 10- and 30-year bonds, and foreign participation was very high. So-called "indirect" bidders, which is how non-U.S. investors typically buy, made up 75% of total bids. That's the highest percentage in six years. Counting all the auctions held in January, foreigners bought 60% of Treasuries on offer. The all-time high for this measure is 63%. So foreign demand for new bonds is just fine.
What is happening is foreign central banks, especially China, are selling. In China's case, this has nothing to do with international politics and everything to do with monetary policy. China wants to keep its currency from collapsing, and is buying yuan and selling dollars to prop up the currency. How do they get the dollars to sell? By liquidating some of their Treasuries!
Does that represent a threat to the Treasury market? Sure. But it would require the currency pressure to become even more acute. That could definitely happen, and a potential catalyst might be the Fed hiking more aggressively than is currently priced in. That would put upward pressure on the dollar, which in turn would put upward pressure on the yuan against all other currencies.
Of course, there would be a flip side of this kind of currency accident. Risk assets might get crushed as uncertainty reigned in China. That would create a flight-to-safety bid for Treasuries.
So I view this as more of a tail-risk possibility. Not only does it require a certain confluence of events, it also is no guarantee that rates actually rise. I view this as a risk that is impossible to price.