Bond Traders Weekly Outlook: Basis Trades, Derivative Hedging, and Levered Speculation

U.S. Treasuries ended the week mixed, the 5-yr note and shorter tenors added to this week’s gains while the long bond gave back some of its advance. The long bond underperformed while shorter tenors saw more speculation about an RRR cut in China and a growing sense that the European Central Bank has reached its peak rate. U.S. Treasuries completed this week’s note auctions Thursday with a B+ $38 billion 7-yr note sale, which met much stronger demand than the 5-yr note offering and the day before 2-yr note auction.

The 2s10s spread ended the week at -18 bps, one basis point tighter for the week. Crude oil reclaimed the bulk of yesterday’s loss after Israel troops entered Gaza, but still gave up $2.52, or 2.9%, for the week. The U.S. Dollar Index gained 0.4% for the week.

Hungry Bond Traders

There is a firm belief the Central Banks have been blindly raising rates because ‘they have to’ and the consequences will be dire, furthermore that the US Administration is bumbling along with damaging decisions one after the other.

The longer rates stay elevated the risk of a downturn increases. This is telling at the margin with more signs of consumer stress as higher borrowing costs and weaker hiring start to eat into household spending. With the Fed seen being close to its policy rate peak, next up is focusing on growth softening.

Understandably, aware of past Fed behavior markets are conditioned for loose conditions. They expect Fed loosening measures to reverse any meaningful tightening, hence constant flipping between end of inflation and hawkish Fed speaks trades.

“Losses on longer-dated Treasuries are beginning to rival some of the most notorious market meltdowns in US history. Bonds maturing in 10 years or more have slumped 46% since peaking in March 2020… That’s just shy of the 49% plunge in US stocks in the aftermath of the dot-com bust at the turn of the century. The rout in 30-year bonds has been even worse, tumbling 53%, nearing the 57% slump in equities during the depths of the financial crisis.” October 4 – Bloomberg (Ye Xie):

Weekly Recap

U.S. Treasuries ended the week mixed, the 5-yr note and shorter tenors added to this week’s gains while the long bond gave back some of its advance. The long bond underperformed while shorter tenors saw more speculation about an RRR cut in China and a growing sense that the European Central Bank has reached its peak rate. U.S. Treasuries completed this week’s note auctions Thursday with a B+ $38 billion 7-yr note sale, which met much stronger demand than the 5-yr note offering and the day before 2-yr note auction.

Treasuries on Friday reversed the lows seen in immediate reaction to the Personal Income/Outlays report for September, which showed a below-consensus increase in personal income (actual 0.3%; consensus 0.4%) coupled with a larger than expected increase in personal spending (actual 0.7%; consensus 0.5%). The core PCE Price Index was up an in-line 0.3% with the yr/yr growth rate slowing slightly to 3.7% from a downwardly revised 3.8% (from 3.9%) in August.

The 2s10s spread ended the week at -18 bps, one basis point tighter for the week. Crude oil reclaimed the bulk of yesterday’s loss after Israel troops entered Gaza, but still gave up $2.52, or 2.9%, for the week. The U.S. Dollar Index gained 0.4% for the week.

Inflation is demonstrating unmistakable persistence, with Middle East instability posing a clear and present danger of higher crude prices. Moreover, an increasingly fragmented global economy elevates the risk of supply chain issues and resource scarcities.

US Treasury Issuance Plans

We a have a slew of central banks decisions this week, no bigger than the Fed but even bigger is the new Treasury issuance note on Monday. The US Treasury announces Q4 marketable borrowing estimates on Monday at 3pmET. It then announces the Q4 Quarterly Refunding Statement that lays out the size and frequency of auctions on Wednesday morning at 8:30amET. This is right into day 2 of the FOMC meeting. Bond traders will be loading up on their Maalox this week.

Recall last time these announcements back on July 31st and August 2nd contributed to the accelerated rise in US Treasury yields. Just ahead of that on the July 27th, the Bank of Japan tweaked its yield curve control parameters that prompted a selloff in Japanese government bonds with trickle over effects into Treasuries. The BoJ is up again this week also.

The size of its quarterly bond sales increased for the first time since early 2021 and then Fitch downgraded the US government’s credit rating from AAA to AA+. More supply, negative ratings action, and voila yields took off.

On July 31st at 3pmET, the US Treasury announced that it had increased the estimated amount of privately held net marketable borrowing for Q3 to US$1.007 trillion which was well in excess of street estimates that had expected a reading in the high 700s or 800s. Two days later, that was accompanied by the Quarterly Refunding Statement (here) that said “Treasury anticipates incrementally increasing auction sizes across benchmark tenors” and backed that up with higher-than-expected auction sizes along with guidance that “further gradual increases will likely be necessary in future quarters.” – Scotiabank

Now this time it shouldn’t be a surprise, the question this time is how much of that expectation has already been priced in higher Treasury yields given the advance guidance. Logic suggests It would take even higher than expected issuance to shock markets.

US banks Preference Toward Maintaining Reserves Impact

There has been a continuation of US banks are showing a preference toward maintaining reserves over US$3T and in order to achieve this the banks are being forced to liquidate their Treasury holdings and hence drive yields higher. Earnings reports from JPM, WFC and C gave us further indication of this pattern.

Still treasury yields continued to move higher despite a growing sense that the bond and stock market are oversold in the short-term and due for a bounce.

De-risking and deleveraging gained momentum this week,

The global bond rout has seen de-risking and deleveraging to gain further momentum. With that comes mounting liquidity and market function concerns. The size of basis trades, derivative hedging, and levered speculation overhangs with unexpected consequences and surprise risk.

The EM dollar-denominated bond bloodbath was unrelenting two weeks ago.

Notable emerging markets yields were up 27 to 35 bps.

Yields were up:

  • 33 bps in the Philippines (5.82%),
  • 33 bps in Peru (6.29%),
  • 32 bps in Turkey (9.05%),
  • 32 bps in Panama (7.21%),
  • 31 bps in Mexico (6.65%),
  • 30 bps in Chile (6.15%),
  • 29 bps in Indonesia (6.20%),
  • 28 bps in Colombia (8.70%),
  • 27 bps in Brazil (7.06%).

Notable local currency EM yield spikes included

  • Lebanon 803 bps (109%),
  • Hungary 39 bps (7.63%),
  • Indonesia 35 bps (7.06%),
  • Czech Republic 33 bps (4.82%).

Key Catalysts that empowered latest Treasury sell off:

“Based on projected intermediate- to long-term borrowing needs, Treasury intends to gradually increase coupon auction sizes beginning with the August to October 2023 quarter. While these changes will make substantial progress towards aligning auction sizes with intermediate- to long-term borrowing needs, further gradual increases will likely be necessary in future quarters.”

August 11 – Bloomberg (Farah Elbahrawy and Greg Ritchie): “US Treasuries are on course for a record year of inflows as investors chasing some of the highest yields in months pile into cash and bonds, according to Bank of America… Cash funds attracted $20.5 billion and investors poured $6.9 billion into bonds in the week through August 9… Meanwhile, US stocks had their first outflow in three weeks at $1.6 billion. Flows into Treasuries have reached $127 billion this year, set for an annualized record of $206 billion, BofA said.”

September 19 – Reuters (Rodrigo Campos): “Global debt hit a record $307 trillion in the second quarter of the year despite rising interest rates curbing bank credit, with markets such as the United States and Japan driving the rise, the Institute of International Finance (IIF) said… The financial services trade group said… global debt in dollar terms had risen by $10 trillion in the first half of 2023 and by $100 trillion over the past decade. It said the latest increase has lifted the global debt-to-GDP ratio for a second straight quarter to 336%. Prior to 2023, the debt ratio had been declining for seven quarters.”

Yield Watch

Friday/Week

  • 2-yr: -2 bps to 5.03% (-6 bps for the week)
  • 3-yr: -4 bps to 4.85% (-7 bps for the week)
  • 5-yr: -3 bps to 4.77% (-9 bps for the week)
  • 10-yr: UNCH at 4.85% (-7 bps for the week)
  • 30-yr: +4 bps to 5.02% (-7 bps for the week)

Key Rates and Spreads

Rates

  • 10-year Treasury bonds 4.83%, down -0.08% w/w (2.60-4.99) (new 15 year high 10/20/23 w/e)
  • Credit spread 1.85%, down -0.04% w/w (1.72-2.42) (new 1 year low 10/6/23 w/e)
  • BAA corporate bond index 6.68%, down -0.12% w/w (1-yr range: 5.28-6.80) (14 year+ high w/w 10/20/23)
  • 30-Year conventional mortgage rate 7.88%, down -0.09% w/w (5.05-8.03) (new 23 year high 10/20/23 w/e)

Yield Curve

  • 10-year minus 2-year: -0.17%, up +0.11% w/w (1-yr range: (-1.07 – -0.17) (new 40 year low)
  • 10-year minus 3-month: -0.63%, down -0.08% w/w (1-yr range: -1.89 – 0.21)
  • 2-year minus Fed funds: -0.32%, down -0.07% w/w
10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity (T10Y2Y)

Money Market Flows

  • Total money market fund assets recovered $24.9bn to $5.633 TN, with a 33-week gain of $739bn (24% annualized). Total money funds were up $1.048 TN, or 22.9%, y-o-y.
  • Total Commercial Paper declined $5.7bn to $1.210 TN. CP was down $90bn, or 6.9%, over the past year.

Bond auctions this week:

Stronger International Demand at 7-year Treasury Bond Auction Completes Week’s Offerings
Weak Demand in 5-Year Treasury Auction Amongst Continued Bond Selling
Steady Demand at 2 Year Treasury Notes Auctions Among Heavy Supply

Bond auctions week ahead:

Next week will bring some new supply.

  • Monday: 13- and 26-week bills
  • Tuesday:  42-day cash management bills
  • Wednesday: 17-week bills; 2-year floating rate notes
  • Thursday: 4- and 8-week bills;

2-, 10- and 30-Year Treasuries Technical Analysis via KnovaWave

Highlights – Federal Reserve

  • Federal Reserve Credit declined $9.5bn last week to $7.905 TN.
  • Fed Credit was down $996bn from the June 22nd, 2022, peak.
  • Over the past 214 weeks, Fed Credit expanded $4.179 TN, or 112%.
  • Fed Credit inflated $5.094 TN, or 181%, over the past 571 weeks.
  • Fed holdings for foreign owners of Treasury, Agency Debt increased $8.0bn last week to $3.433 TN.
  • “Custody holdings” were up $98bn, or 2.9%, y-o-y.
Central Bank Watch – Week Ahead FOMC, BoJ, BoE, BoC, Norges, BanRep, Brazil, Bank Negara

Powell at the FOMC: “I guess it’s fair to say that the economy has been stronger than many expected, given what’s been happening with interest rates. Why is that? Many candidate explanations. Possibly a number of them make sense. One is just that household balance sheets and business balance sheets have been stronger than we had understood, and so that spending has held up and that kind of thing. We’re not sure about that.”

Federal Reserve Kept Rates at 22-Year High 5.25-5.50% Range as Expected

Highlights – Mortgage Market

  • Freddie Mac 30-year fixed mortgage rates rose eight bps to 7.79% (up 71bps y-o-y) – the high since November 2000.
  • Fifteen-year rates were unchanged at 7.12% (up 76bps) – the high since December 2000.
  • Five-year hybrid ARM rates sank 33 bps to 7.06% (up 110bps).
  • Bankrate’s survey of jumbo mortgage borrowing costs had 30-year fixed rates unchanged at 8.03% (up 96bps) – the high since September 2000.
Mortgage News Daily

Global Bond Watch

Higher for longer is a serious threat.

Global Yields Spiking Higher

Surging market yields are a serious issue for a banking system loaded with long duration securities portfolios. This may well be a push over the cliff for troubled commercial real estate (CRE). Leveraged lending and leveraged finance gets more costly. Simply there are trillions of floating rate loans among individuals, speculators, businesses, and nations.

Major Benchmark 10-year Bond markets

Bond Market Performance 2023

Major 10-year Bonds/Notes

Highlights – European Bonds

  • Italian yields dropped 12 bps to 4.80% (up 11bps).
  • Greek 10-year yields sank 21 bps to 4.16% (down 41bps y-t-d).
  • Spain’s 10-year yields declined seven bps to 3.93% (up 41bps).
  • German bund yields fell six bps to 2.83% (up 39bps).
  • French yields declined six bps to 3.45% (up 47bps).
  • The French to German 10-year bond spread was unchanged at 62 bps.
  • U.K. 10-year gilt yields dropped 11 bps to 4.54% (up 87bps).

Italy’s and the UK’s 10-year bond yields are the highest in the G7 after the U.S. as markets continue to worry about the extent of interest rate hikes that will be needed to bring inflation back under control.

Highlights – Asian Bonds

  • Japanese 10-year “JGB” yields rose four bps to 0.88% (up 46bps y-t-d).

Key US Bond Auction Highlights

Inflation Matters

Inflation with Henry Kaufman

Kaufman is the legendary chief economist and head of bond market research at Salomon Brothers is someone who knows Inflation.  Henry Kaufman in an interview with Bloomberg’s Erik Schatzker Jan 14, 2022:

 “I don’t think this Federal Reserve and this leadership has the stamina to act decisively. They’ll act incrementally. In order to turn the market around to a more non-inflationary attitude, you have to shock the market. You can’t raise interest rates bit-by-bit.”

“The longer the Fed takes to tackle a high rate of inflation, the more inflationary psychology is embedded in the private sector — and the more it will have to shock the system.”

“‘It’s dangerous to use the word transitory,’ Kaufman said. ‘The minute you say transitory, it means you’re willing to tolerate some inflation.’ That, he said, undermines the Fed’s role of maintaining economic and financial stability to achieve ‘reasonable non-inflationary growth.’”

Inflation, Disinflation

Core PCE inflation Decelerated in August, Though Energy Prices Cause Concern
US Producer Prices Higher in August, Cost of Gasoline Surged 20%
Cost of Living Crisis Deepens as Consumer Inflation Rises +0.6% in August
FAO World Food Price Index Fell in March for Twelfth Consecutive Month

The rubber is meeting the road as the trifecta of rising interest rates, the Russian invasion of Ukraine and surging costs continues to weigh, this has been no surprise to us here and shouldn’t have been to the market and PTB. You can only play with fire for so long before you get scorched!

With all the redirection of blame at the Fed about inflation one has to understand it is a global phenomenon outside the Fed’s Control. With the war drums louder than ever the supply chain issues are out of control. The Federal Reserve is not in control of global energy and commodities prices.

Everything points to powerful inflationary dynamics and a Federal Reserve so far “behind the curve.”

Instability is pronounced, credit defaults are on track to rise in North America, Europe, Asia, and Australia, according to a survey by the International Association of Credit Portfolio Managers. The economic slump is likely to occur later this year or in 2023, according to the survey.

Global Bonds 2022 Performance

10 Year Bonds – Americas 2022 Performance

10 Year Bonds – Europe 2022 Performance

10 Year Bonds – Asia 2022 Performance

10 Year Bonds – Africa 2022 Performance

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Sources: Scotia Bank, TC, FT

Note these charts, opinions, news, estimates and times are subject to change and for indication only. Trade and invest at your own risk.

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