I was talking to someone at a dinner party and they asked me what I thought of yields, now that we went over 3% in tens last week. For someone who looks at the yield curve all day, I have no strong conviction on direction. Whenever this happens, I like listing all the arguments down and seeing which side makes more sense.
THE BEARISH CASE
- We have strong global growth… more or less. The European data has faltered some, but there is no strong reason to think the growth couldn’t just keep chugging along at 2-2.5%, as it has for the past few years.
- We have signs of some inflation pressures. Core PCE inflation is set to hit the Fed’s target rate of 2.0%. And there are signs that we may get some further pricing pressure, in the form of higher oil and commodity prices. Any trade tariffs could also push prices higher.
- Some think ten year yields should be approximated by nominal GDP. Now that we have consistent 2+% real GDP and 2.0% inflation, you would expect tens to yield about 4.0% in a vacuum.
- I can’t recall a time when a politician promised something and it ended up costing less than their estimates. I’m sure it must’ve happened a few times in the centuries of government spending history. Maybe. Larger deficits mean increased Treasury issuance.
- Fed QE normalization. The Fed keeps increasing the taper, and so a major buyer of Treasuries will keep getting smaller.
- The Fed may at some point start rolling off mortgages more aggressively (relative to Treasuries). They have almost as many mortgages as Treasuries in their portfolio. They probably want to end up with only Treasuries in the portfolio, yet they are tapering reinvestments more with Treasuries than mortgages. Mortgage prepayments will slow with the rise in rates the past year. My keen powers of deduction indicate that all of this means the Fed will have to start unwinding more mortgages somehow – perhaps shifting the composition of the taper. That may not be good for spread products.
- The ECB may be giving details of a further QE taper at the next meeting. They have to tell us what they are planning to do after the current QE taper ends in September. They may give us an indication at one of the meetings starting in June.
- There is no term structure priced into the curve. Any kind of term premium should increase the slope and curvature of the yield curve. I can’t believe people would only want to receive 18 bps to lend this US government money for five additional years between the 5yr and 10yr Treasuries. And I am even more incredulous that people want to lend this US government money for twenty additional years between the 10yr and 30yr Treasuries for 16bps. When any of this “normalizes” we could see the longer end of the US sell off.
- We decisively broke a multi-decade downtrend line a few months ago. We then broke the key psychological level of 3.0%. That’s got to mean something.
THE BULLISH CASE
- Other central banks are still dovish. Draghi and Kuroda don’t seem like they are itching to proceed with QE normalization. If you are an investor in the EU or Japan, 3% yields in the US just looks like free money.
- The longer term FF rate is still under 3%. If the people setting the rates (FOMC) think the longer term rate is under 3%, shouldn’t a “sum of the parts” argument indicate that tens could be capped around here?
- The demographic trend still favors fixed income demand. The first of the baby boomers are 71. But we have a lot more Baby Boomer still to retire, which means pension funds and insurance companies could have more duration matching to engage in.
- There are some structural forces keeping longer term inflation at bay. Technology and demographics (old people are disinflationary) are still there. We also have/had easy flow of goods across countries.
- The current inflation may be “temporary.” Just as last year’s mobile phone price changes were considered “temporary”, you could argue that some of the current price increases (oil, tariff talks, etc) could also be temporary.
- The next two quarterly meetings are highly priced. When meetings are highly priced, there are fewer places on the curve where a selloff could originate. I suppose you could also argue that Kong is keeping the 2019 hikes overly priced, but as previously mentioned, I don’t think he’s wrong absolutely – just relatively.
- The news lately has been bearish for fixed income, but fixed income has not traded bearishly. Equity earnings have been borderline spectacular, we seem to have world peace (Korea, Russia, etc), and Trump was not involved in Russian election rigging. Most of the headlines seem to have been “positive” for the bears. Next week’s price action to large news events could be telling.
So which side will rule supreme? One wildcard could be the Trump Tax Plan – the repercussions of the new tax plan are not clear. We could get the increase in economic activity that was intended (which most economists seem to think), or we could get damaging repercussions in certain markets from the hastily-drafted bill. This is not clear to me.
People who look at the US mostly in isolation should think we get to 3.25+%, while those with a more global view would think 2.75%. For now, I think rates should be lower in the long term (the Fed not hiking as much as planned), but in the shorter term, the move is less clear. But with a data-dependent Fed, the data next week AND the market price reaction could be telling.