With 10-Year U.S. Treasury yields up to a 10-month high around 2.50%, the global economy in a boom, and a few central bankers hovering over the punch bowl and shooing people away, clearly, from a cyclical standpoint, there is a very good case to be made for yields to move higher.
Further, for Treasury market demand/supply mavens, the market structure could not be any weaker: There is a flood of new supply coming with nary a buyer to be found.
In addition, the timing of the Bank of Japan’s (BOJ) decision yesterday to scale back its Rinbans (i.e., economic stimulus) program could not be worse from a bond bull’s perspective. The BOJ is reducing some purchases of its long bonds, again adding fuel to a higher-yield fire burning in the global bond markets.
And today brings the news that the Chinese, having accumulated trillions of dollars in Treasuries, may not be so enamored with them anymore.
The result is Treasuries have had one heck of a start to the year, hovering close to the highs of the expected Trump Bump from last year. Exhibit 1
But is the case for the rally being over so clear cut? Have the secular and cyclical fundamentals changed so much, so quickly?
I remain skeptical. The end of the bond rally may be upon us, but for me to fully latch on to that scenario, I have to see some empirical evidence on a series of expectations. The bond rally is not going to end because it reached some magical number.
Why the Bond Rally Will Continue
First, from a cyclical standpoint, it’s not just growth but core inflation, and core inflation (as opposed to the headline Consumer Price Index) expectations have to change dramatically. So far, core Personal Consumption Expenditures (PCE), the market’s preferred measure of inflation, remain rather subdued and are unlikely to reach the U.S. Federal Reserve’s (Fed) 2% target until 2019. Exhibit 2
Furthermore, for inflation expectations to be unanchored, the Fed would have to abandon its 2% target. I don’t think that is happening any time soon under new Fed Chairman Jerome Powell when he takes over next month. It may be a new Fed, but at its core it is still a traditional Fed.
Second, in my view, the BOJ move, which is the near-term catalyst of the curve steepening if not rising rates, is the BOJ adjusting its purchases in-line with the issuance. Any interpretation that the BOJ is going the way of the Fed in terms of reducing stimulus or changing its core behavior is an overreach.
Third, the idea that the Chinese, or other large exporters for that matter, will stop buying Treasuries just can’t be true. At the end of the day, with the U.S. savings rate already down, the near-term higher growth rate in the United States is likely to lead to a widening trade deficit and the ensuing purchase of U.S. securities as a result of the financing of the deficit. In my opinion, the Chinese are likely to buy more Treasuries, whether they are enamored with them or not.
Finally, from a long-term structural standpoint, the drivers of low rates – global savings, demographics, and technology – are still very much in place. Global savings as a percentage of GDP are still high and, due to higher growth, are even higher in absolute quantity, even if they have come down very modestly in GDP terms since the beginning of the millennium. From a structural standpoint, until global savings come down due to higher consumption in emerging markets (EM) or investments boom in the developed markets (as they continue to come down in EM), the case for significantly higher rates on a global basis is still quite weak.
Given current cyclical conditions, it may seem like an odd time to be making that assertion. Nevertheless, I still believe it is more likely that 10-Year U.S. Treasury yields go below 2% before they go above 3% on a sustained basis. That is not to say that rates can’t go higher in the short run. They could. But I believe that any weakness in Treasury prices should be bought, not sold, by long-term investors.
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