All eyes are peeled on U.S. Treasury bond yields. The equity market has now moved from a negative correlation into a purely positive one, moving in sync with bonds. Why is that? The theory goes that as long as bonds are selling off, with yields moving higher gradually on the back of better economic growth, it is positive for risk assets -- and equities grind higher (negative correlation). But when bond yields move to a level that starts to threaten the rate of growth of the economy, that is when the correlation flips -- and equities start to get nervous and follow bonds lower (positive correlation). This is what has been happening over the past week, as we touched the 3.2% level on the 10-year.
The worry is that the 10-year could go as high as 3.5%, as the market is worried that either the Fed over-tightens or the U.S. fiscal situation will start to weaken. In that case, the two-year yield at 2.88% and 30-year at 3.43% would not make sense, as the market would lean over the 30-year and it would yield much more to price in the risk premium.
In September, the U.S. bond market was very well bid, as September 15 was the deadline for U.S. corporations to deduct pension contributions at the 2017 corporate tax rate of 35%. This provided a bid into the U.S. fixed income market, as American pension funds rushed to buy. This caused the curve to flatten, sending textbook economic signals of a recession ahead.
The bond markets go through periods of demand and supply shocks that can distort the "fundamental" picture. Combined with extreme technical positioning, the true value can be masked over a short period of time.
Investors were extremely long the long end of the bond market, not short, as they were worried about the economy rolling over in 2019, the Fed adamant on raising rates -- and most importantly because of the shape of the yield curve. It was a self-fulfilling prophecy, as a flattening curve made them buy even more at the back end, flattening the curve further and even suggesting a higher probability of a recession.
So, this selloff can just be a flush out of the long positions held by the economic bears. After recent Fed commentary and economic data, there is little reason to believe in a recession, which perhaps caused the unwind?
Liquidity and auction sales are crucial to how the bond markets behave in the very short term. There is no doubt that the bond markets are in a secular downtrend, given the need for central bank to remove the excess accommodation of quantitative easing policy over the past few years. The questions are how soon and how fast?
It was not long ago when bond markets were bid, that the pundits were calling the start of a deflationary cycle. Today, as bond yields shoot above 3.2%, we are now wondering whether the economy can roll over. Typical.
Even secular bear markets can have periods of bull squeezes. If one were to follow Fed Powell's testimony closely, U.S. economic growth is on a solid footing. The big debate is how the economy will fare in 2019 once the tax stimulus effects wear off.
So, one can argue the rate of growth is contained, and there are no signs of overheating -- as judged by the CPI and other Fed inflationary measures. Last Friday's payroll data showed weakness, as numbers missed the official consensus, but it was distorted because of Hurricane Florence. Underlying wage growth and unemployment data was quite positive, pushing the dollar even higher.
We have yet to see how the emerging market demand collapse and trade war games feeds into U.S. economic data. If there is any hint of weakness in the U.S., the Fed will take its foot off the pedal. There is no way the U.S. is immune to the slowdown seen elsewhere. Third-quarter earnings start in earnest this Friday, as banks report. It will be interesting to see how the companies guide on margins, corporate profits and outlook on the back of the U.S./Sino trade war and higher USD costs.
U.S. bonds look tired for the time being, and so does the dollar. After recent liquidation, it seems the risk-reward is on the downside for the dollar and U.S. bonds. Given the flush out, being long the iShares 20+ Year Treasury Bond ETF (TLT) (U.S. Treasury proxy) could be an interesting trade on the long side.