Grant's Interest Rate Observer,

Are Treasuries Going Up Or Down?

Treasury chest

Higher yields across nearly the entire spectrum of U.S. government and corporate bonds should be met with increased demand, right?  Not according to recent dispatches from the Wall Street Journal and the Financial Times.  This morning, the Journal’s Jon Sindreu reports on a relative paucity of foreign demand for Treasury securities despite far more attractive yields on an apples-to-apples basis. Bloomberg’s Lisa Abramowitz notes on Twitter that the two-year Treasury yield premium over the German bund is its highest since 2010.  Sindreu writes:

A year ago, investors were getting around 0.5 percentage point extra for buying a 10-year Treasury and hedging the currency risk every three months, instead of purchasing a German bund, according to the Wall Street Journal’s calculations. They are now losing 00.5 percentage point – a multiyear low.

While demand sputters, Treasury supply remains robust. Yesterday, a $60 billion auction of four-week bills was priced to yield 1.495%, the highest since September 2008 and well above the 1.475% yield available in the when-issued market.  A $22 billion auction of 52-week bills fetched 2.02%, the highest since the 52-week auction was reintroduced in June 2008, according to Bloomberg.  Thomas Simons, economist at Jefferies, commented that: “The surge in bill supply has caused the market to cheapen up . . . there’s value in the yield. How much cash is there to absorb it?”

The investing public seems largely attuned to the bourgeoning supply and waning demand that has characterized the action in USTs.  The Commodity Futures Trading Commission’s weekly Commitment of Trader’s Report for Feb. 20 showed that speculators held 955,593 10-year Treasury futures contracts short, a record quantity going back to 1992 and more than four times the average over that period.  Recall that the February Bank of America Merrill Lynch Global Fund Manager survey showed that 80% of respondents expect that rates will rise over the next year (Almost Daily Grant’s, Feb. 13). Just 5% called for lower rates.

Likewise, the FT yesterday noted that “International investors were net sellers of U.S. corporate paper in December, only the second time this has happened in the past three years.”  Both articles cite the rise in hedging costs as a primary factor in deterring foreign investors from taking the plunge on U.S. debt.

As yields rise, especially on the short end, the Fed’s policy tightening continues apace.  Yesterday, chair Jerome Powell seemed to hint to Congress that four rate hikes were on the table for 2018 (he noted that the December median projection of three hikes has been followed by economic strength, an improving labor market and rising inflation).  Powell also said that the Fed was “moving right along” with its QT balance sheet run-off.

Could the Fed’s unwind of the quantitative easing and zero interest rate policies of the post-2008 era hamper economic expansion which is informing that stimulus removal? Russell Napier, independent strategist and co-founder of the Exchange Research Interchange, writes in today’s “The Solid Ground” commentary that the policy tightening is already having an impact:

In the U.S. M2 [money supply] is growing at just 4.2% year on year, one of the lowest post-WWII levels, while U.S. bank credit growth was growing at just 1.9% y/y in January . . . For bank credit, if not for bond credit, there is ample evidence that higher interest rates are crimping demand and thus destroying the commercial banks’ ability to create money.

Meanwhile, the bond bulls par excellence at Hoisington Investment Management used their Q4 2017 Review and Outlook to explain their rationale for sticking to their guns, in the face of the sharp uptick in short rates and widespread bond bearishness.

We believe the full spectrum of monetary policy is aligned against stronger growth in 2018. A higher federal funds rate, the continuation of QT, low velocity [of money] and abruptly slowing money growth all put downward pressure on [economic] growth. The flatter yield curve will further tighten monetary conditions.

This monetary environment coupled with a heavily indebted economy, a low-saving consumer and well-known existing conditions of poor demographics suggest 2018 will bring economic disappointments. Inflation will subside along with growth causing lower long-term Treasury yields.

For our part, Grant’s remains bearish on bonds, but we also take careful note of the economic and positioning-related indicators which seemingly argue otherwise.