Bond Traders Weekly Outlook: Shorter Tenors Lead the Selling Ahead of Fed

U.S. Treasuries ended the holiday-shortened week on a firmly lower note with shorter tenors leading the selling which reversed a good portion of this week’s gains. The bond market compressed the 2s10s spread by six basis points to -82 bps. The 2-yr note yield fell five basis points to 4.51% and the 10-yr note yield fell 11 basis points to 3.69%. Uncertainty about the debt ceiling finally eased after a deal was passed by both chambers of Congress. The catalyst Friday was the Employment report for May, which saw the NFP crush expectations (actual 339,000; consensus 190,000) however at the same time average hourly earnings growth slowed to 4.3% y/y from 4.4% in April, and the unemployment rate increased by 30 basis points to 3.7%.

The report gave renewed hope a hard landing will be avoided and at the same time the slowdown in earnings growth and the uptick in the unemployment rate suggest the Fed might lean to pause its rate hikes, or at least temper it. The feeling is the report should ease some, certainly not all of the Fed’s concerns about the tightness of the labor market and wage-push inflation going into its June FOMC meeting.

Hungry Bond Traders

There is a firm belief the Central Banks are 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.

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.

Weekly Recap

Treasuries ended the week with gains. The 2-yr note yield fell five basis points to 4.51% and the 10-yr note yield fell 11 basis points to 3.69%. This week’s action compressed the 2s10s spread by six basis points to -82 bps. Crude oil narrowed this week’s loss to $0.90, or 1.2%, while the U.S. Dollar Index rose 0.4% to 104.02, trimming this week’s loss to 0.2%.

The probability of a 25-basis points rate hike at the June meeting plunged to 25.6%, according to the CME FedWatch Tool after the jobs report. Still, Fed officials continue to signal that more rate hikes may be needed. the fed funds futures market, at least 75% expect the fed funds rate range to remain at 5.00-5.25% after the June meeting, but the implied likelihood of a rate hike in July rose to 69.4% from 54.0% yesterday.

Yield Watch

Friday/Week

  • 2-yr: +18 bps to 4.51% (-5 bps for the week)
  • 3-yr: +16 bps to 4.14% (-9 bps for the week)
  • 5-yr: +14 bps to 3.84% (-9 bps for the week)
  • 10-yr: +8 bps to 3.69% (-11 bps for the week)
  • 30-yr: +5 bps to 3.88% (-8 bps for the week)

U.S. Treasuries ended the holiday-shortened week on a firmly lower note with shorter tenors leading the selling which reversed a good portion of this week’s gains. Uncertainty about the debt ceiling finally eased after a deal was passed by both chambers of Congress. The catalyst Friday was the Employment report for May, which saw the NFP crush expectations (actual 339,000; consensus 190,000) however at the same time average hourly earnings growth slowed to 4.3% y/y from 4.4% in April, and the unemployment rate increased by 30 basis points to 3.7%.

Key Rates and Spreads

Rates

  • 10-year Treasury bonds 3.70%, down -0.11% w/w (1-yr range: 2.60-4.25) (12 year high)
  • Credit spread 2.06%, down -0.06 w/w (1-yr range: 1.76-2.42)
  • BAA corporate bond index 5.76%, down -0.17 w/w (1-yr range: 5.00-6.59) (10 year+ high)
  • 30-Year conventional mortgage rate 6.88%, down -0.26% w/w (1-yr range: 5.05-7.38) (new 20 year high)

Yield Curve

  • 10-year minus 2-year: -0.81%, down -0.05% w/w (1-yr range: -0.86 – 1.59) (new 40 year low)
  • 10-year minus 3-month: -1.69%, down -0.18% w/w (1-yr range: -1.69 – 2.04) (new low)
  • 2-year minus Fed funds: -0.58%, down -0.07% w/w.
10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity (T10Y2Y)
Robust U.S. Economy Added 339,000 Jobs in May, Unemployment Rose 3.7% From 3.4%

The report gave renewed hope a hard landing will be avoided and at the same time the slowdown in earnings growth and the uptick in the unemployment rate suggest the Fed might lean to pause its rate hikes, or at least temper it. The feeling is the report should ease some, certainly not all of the Fed’s concerns about the tightness of the labor market and wage-push inflation going into its June FOMC meeting.

Money Market Flows

Money fund assets have expanded an unprecedented $526 billion, or 51% annualized, over 12 weeks to a record $5.420 TN with one-year growth of $894 billion, or 19.7%. Such spectacular monetary inflation deserves serious contemplation.

  • Investment-grade bond funds posted outflows of $2.723 billion, and junk bond funds reported negative flows of $2.174 billion (from Lipper).
  • Total money market fund assets jumped another $31.7bn to a record $5.420 TN, with a 12-week gain of $526bn. Total money funds were up $894bn, or 19.7%, y-o-y.
  • Total Commercial Paper dropped $15.7bn to $1.112 TN. CP was down $27.5bn, or 2.4%, over the past year.

No Bond auctions this week:

10 Year Note Technical Analysis via KnovaWave

Two Year Treasury Volatility was Historic in the First Quarter of 2023

  • Two-year Treasury yields began 2023 at 4.43% then fell to 4.10% by February 2nd.
  • Yields then surged almost 100 bps to trade to 5.07% on March 8th. Volatility was on steroids.
  • Yields were down to 3.71% intraday on the 15th, only to rally back to 4.25% on the 17th.
  • They sank to a low of 3.63% on the 20th, back up to 4.25% on the 22nd,
  • Then down to 3.55% on the 24th
  • Ended the quarter at 4.03%.
  • The yield on the 2-year Treasury fell to 4.06%, down 3.7 basis points on Friday and posting the biggest monthly drop since January 2008, in March the yield fell 73.5 basis points. Its first quarterly retreat in eight quarters.
  • The yield on the 10-year Treasury was at 3.491%, off 5.9 basis points, and recording its sharpest monthly fall since March 2020.
  • The yield on the 30-year Treasury declined to 3.688%, down 5.7 basis points, while setting its biggest monthly decline since January.

US corporate bond spreads over US Treasuries and how they have widened as cyclical risk have risen but are well shy of the wide spreads recorded during the early part of the pandemic, let alone the GFC. To label this as a severe credit crunch would be extreme.

Highlights – Federal Reserve

  • Federal Reserve Credit declined $25.9bn last week to $8.380 TN.
  • Fed Credit was down $521bn from the June 22nd peak.
  • Over the past 194 weeks, Fed Credit expanded $4.653 TN, or 125%.
  • Fed Credit inflated $5.569 TN, or 198%, over the past 551 weeks.
  • Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt rose $12.2bn last week to a one-year high $3.410 TN. “Custody holdings” were up $14bn, or 0.4%, y-o-y.

The probability of a 25-basis points rate hike at the June meeting plunged to 25.6%, according to the CME FedWatch Tool after the jobs report. Still, Fed officials continue to signal that more rate hikes may be needed. the fed funds futures market, at least 75% expect the fed funds rate range to remain at 5.00-5.25% after the June meeting, but the implied likelihood of a rate hike in July rose to 69.4% from 54.0% yesterday.

Federal Reserve Raises Rates 25bps as Expected, Removes Additional Firming May be Appropriate

Jay Powell’s press conference was ‘uncontroversial’. We did see some contrition from him “We are committed to learning the right lessons from this episode and will work to prevent events like these from happening again.”

A bit late given we have seen indefensible mistakes made in pathetic bank regulation. We had inflation mismanagement that is at risk of historic failure. Banking instability adds to downside economic risks, containing inflation leant the bank, at tleast in this meeting to err on the side of overing crushing the economy. Powell repeatedly reminds the risk of repeating past mistakes, where Fed inflation fights ended prematurely.

The FOMC meeting came in the midst of chaos. There was a strong case for the Fed to put off another rate increase. The unfolding banking crisis ensures tighter credit for an economy already downshifting. The case for hiking rates was equally compelling. Inflation remains elevated, with recent data consistently pointing to sticky price pressures. Friday’s strong payroll data, including NFP 253,000 jobs added and a 0.5% (4.4% y-o-y) gain in Average Hourly Earnings confirmed unrelenting labor market tightness.

Bloomberg’s Mike McKee: “Markets have priced in rate cuts by the end of the year. Do you rule that out?”

Chair Powell: “We on the Committee have a view that inflation is going to come down, not so quickly, but it’ll take some time. And in that world, if that forecast is broadly right, it would not be appropriate to cut rates, and we won’t cut rates. If you have a different forecast – markets have been from time-to-time pricing in quite rapid reductions in inflation – we’d factor that in. But that’s not our forecast. And, of course, the history of the last two years has been very much that inflation moves down [gradually]. Particularly now, if you look at non-housing services, it really, really hasn’t moved much. And it’s quite stable. So, we think we’ll have to – demand will have to weaken a little bit and labor market conditions may have to soften a bit more to begin to see progress there. And, again, in that world, it wouldn’t be appropriate for us to cut rates.”

Central Bank Watch – Deluge of BOE, ECB and Fed Speakers including Powell and Bernanke

Highlights – Mortgage Market

  • Freddie Mac 30-year fixed mortgage rates surged 25 bps to a six-month high 6.76% (up 166bps y-o-y).
  • Fifteen-year rates jumped 29 bps to 6.09% (up 178bps).
  • Five-year hybrid ARM rates spiked 29 bps to 6.28% (up 208bps) – the high since October 2008.
  • Bankrate’s survey of jumbo mortgage borrowing costs had 30-year fixed rates up 16 bps to 7.17% (up 193bps).
Mortgage News Daily
US Mortgage Applications Fall 4.6% With Mortage Rates Highest Since March

Global Bond Watch

“Government bond prices around the world are moving in tandem, reducing investors’ ability to diversify their portfolios and raising concerns of being blindsided by market gyrations. Correlations between currency-adjusted returns on the government debt of countries such as the U.S., Japan, the U.K. and Germany are at their highest level in at least seven years, data from MSCI showed, as central banks around the world ramp up their fight against inflation.”

October 10 – Reuters (Davide Barbuscia)

Major Benchmark 10-year Bond markets

Bond Market Performance 2023

Major 10-year Bonds/Notes

Highlights – European Bonds

  • Greek 10-year yields dropped 21 bps to 3.69% (down 88bps y-t-d).
  • Italian yields sank 32 bps to 4.07% (down 63bps).
  • Spain’s 10-year yields fell 29 bps to 3.32% (down 20bps).
  • German bund yields slumped 23 bps to 2.31% (down 13bps).
  • French yields dropped 25 bps to 2.86% (down 12bps).
  • The French to German 10-year bond spread narrowed two to 55 bps.
  • U.K. 10-year gilt yields declined 118 bps to 4.16% (up 48bps)

Gilts Sold Reminds us of Risk

The prior week we saw the yield on UK two-year debt rose 0.6 percentage points week to over 4.5 per cent, its highest level since October. The equivalent German bond yield rose from 2.5 per cent early this month to just under 3 per cent.

The UK’s 10-year bond yields are the highest in the G7, as markets continue to worry about the extent of interest rate hikes that will be needed to bring inflation back under control. There was some nervousness in bond markets globally Thursday when British bond prices tumbled again on Thursday with concerns high inflation will force the Bank of England to carry on raising interest rates, with two-year gilts on track for one of the biggest weekly falls in 20 years.

Gilt yields were up on the day around 11 to 17 basis points (bps) over the range of maturities, adding to a similar jump on Wednesday as markets reeled from stronger-than-expected inflation data. Markets have repriced one more rate rise by the European Central Bank to 3.7 per cent from 3.5 per cent by October.

This all happened quickly…. just months ago we had:

German 10-Year Bunds at Weakest Level since July 2011 as Yield Curve Inversion Deepens

Highlights – Asian Bonds

  • Japanese 10-year “JGB” yields declined a basis point to 0.41% (down 1bp y-t-d).

“The unprecedented monetary easing by the Bank of Japan over the past decade has reshaped the nation’s lenders, from their asset holdings to loan income. That may be about to change as the central bank prepares to take on a new chief next month… The most notable case is Japan Post Bank Co., a unit of a former state-run mail services giant, which manages most of almost $2 trillion of assets in its securities portfolio. Where it once invested as much as 80% of its money in JGBs, this now accounts for less than 20%. Instead, the bank has rapidly built up its holdings of foreign bonds and other securities to 78 trillion yen ($572bn), accounting for about 35% of its entire portfolio.”

March 5 – Bloomberg (Taiga Uranaka)
Deja Vu as Dollar Yen Soars After Bank of Japan Keeps Monetary Policy Steady, No Change to JGB Yield Band

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

Robust Increase in Real Spending with Core PCE Inflation at Persistently High Levels in April
US Producer Price Inflation Moderates Again in April, +2.3% versus +2.7% in March
Consumer Inflation in April Eases with Fed Screws Tightening, Core CPI Stays Elevated
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

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