Here's Why Bonds Are Pausing, and Why Yields May Resume Their Rise

While U.S. economic reports keep surprising to the upside, bond yields fell for the second week in a row. This strange dichotomy has brought rise to a theory that perhaps macro data are peaking, which in turn will remove any catalyst for bond yields to keep rising. While I think it is likely that the data are peaking in a certain sense, this makes for a poor thesis on the direction of rates. Here's the real reason why U.S. bonds are taking a pause now, but also why yields are likely to resume rising in the coming weeks. Could economic data be peaking now? In a certain sense, this is probably as good as economic data get. Last week Retail Sales came in at up almost 10% month over month, Empire Manufacturing was at a seven-year peak and the Philly Fed was at almost a 50-year high. Clearly these kinds of numbers can't be repeated month after month. Any statistic that measures a short-term rate of change may very well be posting the best result of this cycle right about now. That goes double for any year-over-year measure, because a year ago marks the pandemic's onset. However, for rates traders, the rate-of-change data are fairly meaningless. The key driver for rates will be how quickly the economy runs out of capacity. That is when lasting inflationary pressure becomes most likely. Hence, the percentage change in the total isn't as important as how much closer that figure is to total capacity. For instance, by the time unemployment gets to 4.0%, I'm sure the monthly payroll gain figures will be smaller than they are now. But at 4.0%, labor shortage problems will be much more acute. At that point even a modest increase in hiring will have a big impact on wages. That is what will cause inflation to accelerate and then what ultimately will cause the Federal Reserve to respond. Is stimulus wearing off? A related idea to the peak data theory is that the effect of fiscal stimulus is waning. Again, in a sense this is obviously true. The biggest effect of the most recent stimulus bill is the big check many households received. It stands to reason that the largest measured effect on the economy would come shortly after people got the money. It is pretty clear that stimulus payments were a big part of why Retail Sales spiked. However, to claim that Treasury yields are falling because of diminished stimulus effects suggests that markets were unaware that the stimulus effect would eventually end. We always knew that there would be a short-term impact from stimulus and savings drawdown as the pandemic came to an end. We also knew this period might coincide with some supply-chain disruptions that could cause inflation. The real key for rates is what happens after all that has passed. Here again we see the key fundamental is how tight the economy gets. In the very short term, we may see the thrust from stimmy checks diminish and we may see supply chain challenges get ironed out. The question is whether the economy is out of capacity by the time all that occurs. Technicals are driving rates lower, but... There are two related factors pushing rates lower right now, and neither of them have anything to do with interest rate fundamentals. First, U.S. rates have gotten very attractive to either euro-based or yen-based buyers, even after hedging back to their home currency. Right now after the cost of hedging, a yen-based buyer earns about 26 basis point more buying U.S. 5-year bonds vs. 5-year Japanese bonds. For a euro-based buyer the advantage is 61 basis points. There have been persistent rumors that a very large Japanese investor has been buying U.S. bonds in the last couple weeks. I don't know whether the rumor of a single Asian buyer is true, but it is very likely that non-U.S. buying has picked up in recent days. Second is that the short base on Treasuries keeps getting squeezed. We saw something similar in October/November when some fast money was trying to play a reflation by shorting Treasuries, only to get squeezed out periodically in violent bond rallies. That's what this past Thursday felt like after the Retail Sales report. The 30-year Treasury rose by over two points and was building strength the whole day. There was a similar but not as dramatic feel to Tuesday. All these factors will come and go. This kind of foreign buying will only persist as long as Treasuries remain cheap. Short squeezes only last until the short base has diminished. Ultimately, rates will be driven by inflation and the Fed's response to inflation. Timing is tough, but rates are going higher Could it be that rates stay in a nearby range for a while? Definitely. Maybe it will turn out markets have overestimated inflation pressure for one reason or another. Maybe stubbornly low non-U.S. rates result in a persistently strong bid for U.S. bonds. These are distinct possibilities. However, these are scenarios where rates are about unchanged. They aren't scenarios where yields fall in a meaningful way. For all our surprise over the recent rally in bonds, yields closed on Tuesday a whopping 18 basis points off the near-term highs and are still higher than where they closed as recently as March 11. In the scheme of things, this rate rally is very small. Most likely it merely reflects some rotation of positioning, and elevating it into something greater than that would be a mistake. Nothing has changed about the underlying narrative. The economy is recovering quickly, job growth is robust, and wage pressure is growing. This makes the possibility of lasting inflation very real, and that possibility will very likely result in bond yields continuing to rise.

Here's Why Bonds Are Pausing, and Why Yields May Resume Their Rise

The possibility of lasting inflation is very real, and that possibility likely will result in bond yields continuing to rise.

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