The “common sense” narrative is that the economic data has been good and we just got tax reform.  A $1.5trillion deficit means that much more debt that needs to be issued and a boost to the economy.  3.0% tens, here we go!  I mean the Fed’s long run FF projection is 2.75%, and most of them don’t assume any kind of substantial fiscal stimulus.  Add some increased term premium on the curve and we could be off to the races.  This would make complete sense if the US was not so linked to the policies of other major economies.  But we are.

The long end just doesn’t seem to want to sell off.  EDZ9-Z0 just settled at a new five year low, and so did every other year spread further out the curve.  This is not the sign of tens (or thirties) that is going to go ripping higher in yield.  Where’s the term premium?!?  Where is the convexity in EDs?  The answer of course, is that US rates are affected by extremely low rates in other countries by a bungee cord.  The bungee cord right now looks overly stretched.

Granted, we officially had the Senate pass tax “reform” Friday night.  So maybe that will be rocket fuel for tens next week.  Yawn.  But that should have been mostly priced in.  ABC retracted some of their Flynn story, also on Friday night.  Maybe that’s worth another few bps.  I’m just not sure this is enough to get the job of breaking the longer end downtrend lines.  Maybe on a really strong Employment Report – we are always data-dependent, after all.

Call me Captain Obvious, but it seems to me that: (1) ten year yields are about to take off for the obvious reasons just mentioned, or (2) we are either on the verge of a large short squeeze.  Why a short squeeze?  Why couldn’t we just sit here?  Because as the bungee cord gets stretched further, it either snaps or it bounces back more.  There seems to be too much energy in the bungee cord right now and this is not what looks to be an equilibrium curve.  ERZ0-EDZ0 is at 205.5bps (7bps wider than a week ago).  That’s pretty wide in a yield-grab environment.  I’m not bullish, mind you – I’ve been bearish US fixed income for most of the year (on 2018 hikes), and I’m still very constructive on growth.  I’m just not sure about inflation.  But here are the reasons (pre-NFP) that make the bearish story a little more concerning:

  • EDH8 rallied 2 bps on Friday. The contracts behind EDH8 were better offered.  It’s not a compelling bearish story when the markets take out the next quarterly meeting (after the likely Dec hike), in favor of the meetings behind.  Pricing in a slowing pace of hikes with a selloff is not as compelling a case for the bungee cord breaking.  Most of this could have been the Flynn story, and ABC did have a retraction over the weekend on implications for Trump.  Let’s see what happens.  For most of the year, I thought we needed to see more hiking in 2018 priced in – especially if the longer end downtrend is going to break.
  • EDU9-U0 spread and most of the year spreads behind made new 5 year lows. Most of this is just the yield curve flattening from more hikes being priced in on the front end.  However, this gives no support to the theory that the Fed tapering is putting term premium back on the curve.  So if you are selling tens thinking there should be more term premium on the curve, and the markets are pricing in less on the selloff, that probably means either you or the markets are wrong.  Captain Obvious strikes again!
  • Inflation in Europe and Japan are weaker. Headline CPI in Japan is 0.2%.  That is year-over-year, NOT month-over-month.  Eurozone HICP disappointed at 1.5% (from 1.6% consensus).  Those countries’ central banks only have an inflation mandate.  The US tax reform is going to cause a $1.5 trillion deficit, which is a lot.  But that is over 10 years.  $150B  a year is less impressive.  $150B is what the BOJ and ECB buy in less than 2 months.  I don’t want to sound like Captain Obvious again, but which is more important?
  • There were a lot of shorts last week (ie JPM client survey), and the way the curve looks to me, there could be more shorts this week in the belly of the curve. I suppose I could have also just done the obvious thing (seen that we sold off on the week), just put 1 and 1 together, and concluded that there are more shorts this week.  Maybe I’m not Captain Obvious.  Just because a trade is crowded doesn’t mean it can’t keep going.  It just makes any kind of exit ugly, supporting my theory that we probably won’t sit here.
  • I was listening to someone at a large insurance company and he seemed really happy with making 50-100bps over Treasuries on private mortgages and bonds. He kept saying, “we’re never going to be able to get out of these, but…”  No kidding.  Liquidity premiums are apparently also going lower.  This guy would probably be wetting himself if Treasuries sold off 50bps.  He’s not alone.  Calpers is supposed to be voting on doubling their fixed income allocation later this month.  Alibaba’s debt offering was 7x subscribed.  And I’m guessing there are tons of companies in Europe staring at 0.30% Bunds and companies in Japan looking at 0.04% JGBs looking at US tens on the bungee cord thinking, “yum!”  I’m not saying we couldn’t sell off, but there could be many people lining up to buy US fixed income on dips.

The part making reading what is going on in the curve difficult is the 10+bp rally after the Flynn news came out.  Equities came back nearly all the way to the highs, but fixed income settled closer to mid-range.  It’s not clear how the market positioning changed, and on top of it, the Senate passed tax reform over the weekend.  People will have had a weekend to digest the implications, so let’s see what happens.  But there seems to be a lot of energy stored in the bungee cord.  This, combined with the Employment Report coming out next week could give us a larger-than-expected move in rates next week.