How the 10-Year Treasury Yield Slip Tripped Up Investors (Like Me)

The 10-year U.S. Treasury on Wednesday morning fell below 1.50% for the first time since early March, confounding those (including yours truly) who have been expecting yields to keep rising. Whenever a trade isn't going as you expect, it is crucial to ascertain whether you have a bad thesis or whether your thesis just hasn't played out. I'll give you my assessment as to why bonds are rallying and how durable this rally might be. Narratives Changing The biggest reason why bond yields have stalled out is that we've gone from a runaway economy narrative to a growth has already peaked narrative. Let's not forget that for March, the jobs report, which was released April 2, showed a 916,000 gain. At that time, Federal Reserve Chair Jerome Powell felt he needed to tamp down rate-hike expectations. This prompted him to say he wanted to see a string of 1 million or more job gains before even acting on Quantitative Easing tapering, much less hiking rates. After the last two job reports disappointed, it now looks like the big gain in March was the outlier, and it sure doesn't seem that there's much chance that a string of million job months is imminent. Hence, there is little surprise that forward markets have greatly reduced expectations for Fed rate hikes. On the day the March jobs report was released, futures markets expected between four and five rate hikes by year-end 2023. As of Wednesday, that was down to only three. Is this new narrative correct? I'll get to that, later on. Technicals Favorable I've mentioned a few times that U.S. bonds remain very attractive for non-U.S. buyers. The U.S. 5-year Treasury hedged to euros yields 65 basis points more than German Bunds; hedged to sterling, it's 43bps more than U.K. Gilts; and, hedged to yen, is it 37bps more than JGBs. These relationships have been very steady since March, meaning the combination of global yields and hedging costs have moved in close consort with U.S. yields. That might mean that the changing narrative in the U.S. is similar around the world, or might mean that global buyers are setting the levels by what levels they find attractive. Another key technical is bank buying. With T-Bill rates so low, and with T-Bill supply drying up as the Treasury spends down its excess cash, banks have had to look elsewhere for highly liquid holdings. That demand has spilled over into two to five year Treasuries, and falling yields in there has dragged the rest of the curve down. Lastly, I think interest in shorting Treasuries has dried up. Shorts on the Long Bond futures contract are down about 20% from the March average. Although those commitment reports can be deceiving, it fits the chatter I've heard from other traders that hedge funds are not shorting the market like before. No Obvious Short-Term Catalyst One reason why hedge funds may be less excited about shorting bonds is the lack of an obvious short-term catalyst. We are currently experiencing a surge in inflation data: On Thursday Core CPI is expected to be 3.5% year-over-year, which would be the highest print since 1993. And yet it is widely agreed that this is all transitory. Given that, it doesn't matter much if the data beats or misses, markets will ignore it either way. In other words, nothing about near-term inflation data will move the needle for the Fed and given that, hard to see how inflation data alone pushes bond yields higher than the recent range. Perhaps employment numbers could move the needle, but it would likely take at least two really strong months to reverse the narrative. One month might get dismissed as a catch-up from the bad April/May reports. Besides, if jobs heat back up, but the market remains skeptical about inflation, it won't necessarily change the narrative about the Fed or rates either. My Thesis Isn't Broken Given all this, I do think rates can stay around this low for a bit. However, my basic thesis isn't broken at all. My argument all along was that inflation would come in two phases. The first is what we're going through right now, where a surge of post-pandemic demand collided with pandemic-induced supply chain challenges. Throw in a little base effect, and you get the highest Core CPI read in three decades. This phase will indeed be transitory and is of no moment to the Fed. The second phase will be driven by a tight labor market and ensuing wage growth. In January I thought it would take until late 2022 before we reached full employment, using a back-of-the-envelope guess of around 510,000 jobs added per month. Since I wrote that we've added 478,000, so based on my original thesis, we aren't very far off. Meanwhile, we are seeing very clear signs of rapid wage growth, both in anecdotes from companies and in hard data. There's no reason to think this is transitory. Moreover, the effect of higher wages effects every company, unlike say the price of lumber. It is by far the most pervasive input cost companies face. Lastly, we are learning something about long-term inflation potential right now. The vast majority of companies that we cover are able to pass through input cost increases to customers without much trouble. This tells us that companies have pricing power, which is the necessary ingredient if cost-push inflation is going to be a thing. Even though some of the specific supply-driven cost pressures subside, the wage pressure issue will persist. If companies still have this level of pricing power, that will result in higher wages turning into generalized inflation. If anything, my thesis is getting stronger. As I wrote last week, there's some nascent evidence that labor supply is coming back online more slowly than anyone would have guessed. If that's true, and at this point it is still a big if, that will only make wage-pressure worse. Time Horizon Must Match Thesis Many hedge funds seem to be exiting short positions in bonds now. That makes perfect sense to me, if you want a trade that will pay off in the next few weeks. Bond yields could certainly move higher in the next few weeks, but it will probably be within the recent range. Any big move higher is probably a month or two away, if not more. However, my thesis, and hence the way I've comported my portfolio, had a longer time horizon in mind. For a pure bond manager like me, that means running with a high enough overall portfolio yield that we could still perform even if rates were to reverse a bit. We've also used tools like mortgage bonds that benefit from higher yields, but won't get killed in a steady-state market. If you are thinking about your own bond position, I encourage you to think about rates in this manner: probably going up, but it might take a couple months before that actually happens. However, this is also some more general advice on trading. Make sure your thesis is well documented, so as I showed above, it is easy to compare what you expected to what's actually happening. Beyond that, make sure you have staying power to see out the time horizon in which your thesis might play out.

How the 10-Year Treasury Yield Slip Tripped Up Investors (Like Me)

When a trade veers from what you expect, it's crucial to find out whether you have a bad thesis or it just hasn't played out yet. Here's my take.

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