Now that the ten year yield is back near the recent highs, I’m a little uncertain as to how far this goes.  If it wasn’t for the downtrend that everyone seems to be looking at, I would probably say we could sell off a lot more.  As previously mentioned, it’s just a question of when the downtrend breaks – not if it breaks.  But when something has held this long, people have made careers just being long fixed income, and net central bank buying is still positive, it’s going to take a strong confluence of factors.  I thought I would look at the curve from a bottom-up perspective and re-evaluate what things I still believe in.

  • The Dec 2017 meeting. There are currently 20bps priced in.  Now that tax reform looks more possible, it would really take some terrible data (that can’t be explained away by storms) for the Fed not to hike.  I know we still have 2 payrolls to get through, but barring some shocking data, it looks like we should be selling off another 5bps here by the end of the year.  That is going to put some upward pressure on the downtrend line.
  • The 2018 meetings. Even with the recent selloff, there are still less than 1.5 hikes priced into 2018.  I can’t get excited about unwinding 2018 steepeners, unless we get to at least 2 hikes.  So that means we have another 13.5bps to sell off, just to get to the lower end of where I think the 2018 hikes should be.  I may just keep these and instead sell some 2019 meetings against them…
  • The 2019 meetings. I still hate 2019 meetings on a relative basis, assuming the Fed is going to be gradual and the longer term rate could be as low as 2.5%.  This is because we can get to 2.5% with a hike this year and 4 hikes next year (which could still be considered “gradual”).  So we either need to think the Fed could be even more gradual, or the longer rate FF rate is going to start increasing, or that we get some term premium back.  Any one of these are clearly possible, which is why on an absolute basis the 2019 year spread could be low.  But I think playing for the second hike in 2018 first makes more sense, before I start putting more hikes in 2019 and the longer end of the curve.
  • Do we get term premium back? The return of term premiums should cause more slope and curvature in the long end of the curve.
  • We are going to have more US Treasury issuance. A deficit-fueled tax cut could cause the curve to steepen more.  The longer end may be spooked by the “$1.5 trillion” cost of the tax cuts.  But my over/under for the US debt by 2035 is $50 trillion.  The Social Security trust fund is supposed to run out of money by then.  We have increased Medicare for an increasing elderly population and increased debt service.  Don’t forget all the states we will have to bail out before then.  The markets are happy holding 10s-30 flatteners for 52 bps as we approach that future environment.  Enjoy clipping those coupons… in front of the fleet of oncoming bulldozers.

Just looking at the above, you could make the argument that we “should” break the tens downtrend line this year.  However, it’s hard to see the bulls wanting to give up just based on the events of the past few weeks.  I think we may need either a very hawkish surprise by the ECB next week, or another very strong payroll the following week for a real shot at breaking the downtrend.  In the meantime, I think we have to remain tactical.