While I am still quite confident that interest rates will remain low for the foreseeable future, I am a little worried about the outlook for treasuries.
Don’t get me wrong. The fundamentals case for rates remaining low is still quite solid based on: a) modest global growth, b) low inflation, c) a slowdown in emerging markets, d) a tightening of financial conditions (i.e., a stronger dollar, higher corporate bond yields, etc.) in the U.S., and e) equity market vulnerability due to the expectation of additional Federal Reserve interest rate hikes and corporate earnings pressure. This is likely to be the case for some time.
However, the price action in the treasury market is, in the midst of chaos in global equities, surprisingly, very muted. Yes, treasuries are rallying while equities are selling off, but not as much as one would expect given the depth of the selloff in equities. In the past, for a similar selloff, treasuries would have been comfortably through 2% by now. Today, despite a deep global equities selloff, 10-year treasuries have barely budged.
That, in my view is quite problematic. Not because I think interest rates are likely to rise back to, say, 3% any time soon. Instead, my worry is that the outlook for treasury prices is becoming quite skewed. As a result, the rallies are likely to be shallower while the sell-offs will become more pronounced. From a positioning standpoint, what that implies is cash, rather than long treasuries, is becoming the safe haven.
Global Forces Driving Treasury Prices
I am not exactly sure what the cause of this new development is. One hypothesis could be that international reserve managers and central bankers are selling treasuries to support their currencies, the so-called Quantitative Tightening theory. While that is possible, it seems improbable based on the price action of various points of the treasury curve. No one sells 10-year treasuries to support their currencies. They are more likely to sell shorter treasuries, which they hold specifically for that purpose.
A more likely cause, in the view of some of my colleagues who focus more on the international markets, is that the quantitative easing-related financial easing in Europe is fading. As a result, European government bonds are selling off.
Further, the European economic environment is improving while the U.S. is slowing, which in turn exacerbates the selloff in European government bonds. Additionally, as Europe improves, flows into hedged European equity funds have gone down. That, in turn, is strengthening the euro, further aggravating the potential negative impact on treasuries of the selloff of European government bonds.
Implications for U.S. Economy, Markets
If indeed this price action persists, and it is too early at this point to come to the conclusion that it will, it may have significant implications for the economy and the markets:
- Financial conditions will continue to tighten in the U.S. leading to a rise in real interest rates.
- The U.S. dollar will strengthen more than what would be expected otherwise due to higher rate differentials.
- The U.S. economy would become more vulnerable, making all risky assets more vulnerable in turn.
So far, I have given very little credence to the Quantitative Tightening market meme. However, the price action in treasuries the last few days certainly makes me wonder if there is some kernel of truth to it.
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