Now that we have Data Week over with, the rest of the month should have less noise than average.  However we have the following considerations for the rest of the month:

  • North Korea. As mentioned previously, there is a 1.5 week window between China’s Golden Week, and the National Congress.  What a “coincidence” that we got some chatter for early next week!  I’m not sure we get anything, but the market is probably very short fixed income.  The last JPM survey was extremely short, and we sold off more last week.  While I think we did get some short covering going into the weekend, the possibility of a short squeeze in thin holiday markets exists.  If we don’t get one, that is bearish.
  • We should get the decision on the new Fed Chair in the next week or two. I continue to think Powell/Yellen is the better decision for a logical President that wants lower rates, continuity and to keep the economic momentum going.  But logic is not one of Trump’s strong traits.
  • ECB meets October 26, and they are supposed to give us some tapering details. EURUSD dropped about 3% from the highs a month ago.  Since we all know European QE is a ruse to weaken the Euro, what we get could depend on what the currency does.

Rather than go through a number of news scenarios, I thought we should just look at the simple scenario where we don’t get any new news.  This is the most likely scenario, and depending on the news (source of market move), the curve reaction could be different.  What could a potential non-event break look like?

1. LOWER YIELDS (break to the downside)

Let’s look at this bottom-up.  The Fed is most likely going to hike in December.  We are almost 20bps priced in.  Assuming nothing surprising happens, as time goes on, we should get the last 5bps to price by year-end.  It’s not clear to me how much of the Dec hike is going to get taken out on a rally (if at all).  That puts some strain on the rest of the curve in a rally scenario.

We currently have 33.5bps priced in for 2018.  1.34 hikes for 2018 is still low, unless you see some kind of recession or slow-down scenario.  Warsh is probably in a 4+ hike camp for 2018, and I’m guessing Powell and Yellen are in the 3 hike camp.  So I’m not sure this 2018 pricing is going to change more than a few bps to the downside without some type of news.

And that leaves 2019 and 2020.  EDZ0 is somewhat close to being a proxy for tens, so this brings us to our good friend, the EDZ8-Z0 spread.

You could make an argument for this chart being bullish or bearish in the short term.  Most of the room for a break lower in yields is going to come from EDZ8-Z0 going lower.  But there are only 5bps to the old 28.5 support level.  I suppose there is nothing written in stone that says the support can’t break.  But 28.5 does seem to be a “bare bones” level in an environment where the Fed thinks we’ll eventually get 100bps of term premium back on the curve – when (global) QE is over with and balance sheets are reduced (whenever that is).

Barring news, there could be room for about 10bps of a rally if EDZ8-Z0 drops 5bps, and the markets take off another 5bps before EDZ8.  Maybe.  It seems like for this to happen, we would need some kind of short squeeze.  The bearish positioning does seem high, we got our fearless President Twittering over the weekend, and we do have thin holiday markets on Monday.  Predicting a curve move on a rally is difficult with North Korea tensions going into October 9-10.  But unless something actually happens (missile firing, nuclear detonation, etc), I’m not sure we can rally that much more than the 10bps.  I’m just not sure where the larger rally is going to come from without an “event.”  A North Korea “event” could cause a greens-led rally with the flies going lower (depending on the event).  Otherwise, you would expect more of a bull flattener, possibly with the front flies being little-changed.

2. HIGHER YIELDS (break to the upside)

We probably need about 5-10bps to break the downtrend line (depending on how you draw the line).  Doing the same type of analysis on an upside yield scenario, we could get a couple of bps in the Dec meeting, we could easily get 5-10 more bps on 2018 meetings (perhaps a lot more), and we could get some longer end bps on a term structure move.  It’s not difficult to image a large move higher in yields – especially in light of a deficit-fueling tax cut plan going into an election year.  I think we should bear steepen, but the potential for longer end steepening could be temporarily capped by the downtrend line.  Of course, when we break BOTH the 10 year and 30 year lines (the 30 year trend line is much further away), we will be off to the races on steepening.  But we would probably need a catalyst for that.

I’m not sure if anything will happen Monday or Tuesday.  Assuming North Korea plays nice, I think sticking to the very front end selloff (around reds) makes sense until we break the 10 year downtrend line.  This is because the front end steepeners would converge to actual Fed hikes (assuming the Fed is right).  And even when the downtrend line breaks, the front end steepeners will get dragged along for the ride.  If we get an “event,” then the curve shape will depend on the type of news.  Watch for new trades and curve thoughts in the daily emails.