I don’t know about everyone else, but I’ve heard just about all I care to hear about the extent to which 3% on 10s either does or doesn’t presage the end times. Or maybe I haven’t because here I am writing about it and thus perpetuating the very same argument that I claim to be sick of hearing, but you know, c’est la vie.
I guess, like everyone else, “I’ve got a fever. And the only prescription is more posts about 10Y yields.”
We’ve been waiting on the “magic” 3% moment since long end rates began their steady push higher off the “Irma Friday” lows near 2% back in September and while there are undoubtedly all manner of trades tethered to that threshold, market participants have worked themselves into a veritable frenzy over this. We finally got there this week and although Treasurys rallied on Thursday (helped along by a 4bp slide in bund yields following Draghi’s presser), we’re still “uncomfortably” near 3% and that’s hanging over markets like smog on a particularly polluted morning in Beijing.
If you’re a person who cares about such things – and if you’re worried about an imaginary “line in the sand”, then you almost by definition are – then it’s perhaps worth noting that bonds were looking oversold as of Wednesday:
But truth be told, everyone would probably be better off remembering what Morgan Stanley’s Matthew Hornbach said about this situation two months ago, when he came out bullish on the long end following the bear steepening episode that accompanied the February inflation scare. To wit, from Hornbach:
History has shown that consensus estimates for Treasury yields are usually wrong [and] everyone understands that accurate point forecasts rarely occur.
Right. And that’s in no small part due to the sheer number of factors that go into determining what the long end does. And if it’s nearly impossible to accurately forecast yields, well then it’s even more difficult (assuming something can be much more difficult than “nearly impossible”) to forecast what the pain threshold is on the 10Y for stocks because now you’re dealing will even more embedded contingencies, especially considering that in the post-crisis environment, it seems entirely possible that the historical “pain threshold” (and by that I just mean the level beyond which the stock-bond return correlation flips sustainably positive, thus leading to acute diversification desperation) of between 4.5% and 5% on 10s no longer applies. Indeed, some evidence from the Taper Tantrum seems to support the notion that the “danger zone” (as it were) for 10Y yields is well below what it’s been in the past if for no other reason than the post-crisis experience has conditioned everyone to redefine what “high” yields are and adjust their positions, leverage, etc. accordingly.
All of this is complicated immeasurably by the fact that pulling in one direction (up in yields) is the deteriorating U.S. fiscal position and the potential for a rebuilding of the term premium, while pushing in the other direction (down) is haven demand during acute risk-off episodes, relatively attractive yields (hedging costs notwithstanding), and portfolio rebalancing. Those latter factors have pushed vol. away from rates of late.
Over the longer haul, the fiscal deterioration (defined as it is by Trump’s ill-advised decision to pile stimulus atop an economy operating at or near full employment) and the Fed’s efforts to rundown the balance sheet will almost invariably spell trouble. As noted earlier this week in a particularly amusing piece over at HR, the IMF now projects the U.S. will be in worse fiscal shape than Italy by 2023 and if their projections pan out, America will also look worse on the debt sustainability front than Mozambique And Burundi.
It’s worth noting that bonds actually rallied in 2011 after the infamous S&P downgrade as the jitters that downgrade triggered paradoxically created a bid for the very same assets that were downgraded, but as BofAML points out in a piece out Thursday, it’s not entirely clear that kind of dynamic is going to prevail in the future. To wit:
The 10yr US Treasury yield breached the 3% mark on Tuesday – a level seen only twice since mid-2011. Year-to-date, this represents a roughly 60bp jump in yields. Stock markets across the globe, however, have faltered in 2018, with the Dow Jones is down almost 3%. For years, the US Treasury bond has been seen as the safe haven par excellence – a high-quality asset that would rally in times of market stress and offer welcome diversification for investors’ risky portfolios. Recall that in August 2011, when S&P downgraded the rating on US sovereign debt from AAA to AA+, 10yr Treasury yields actually declined by around 60bp during the ensuing 6w. But this year, Treasury performance has been akin to a risky asset. Our US rates team have highlighted numerous reasons for structural upward pressure on Treasury yields, including the Fed’s balance sheet shrinkage, higher US Libor rates and importantly…the jump in the US budget deficit.
And if you’re one to extrapolate, one possibility here is that when the chickens finally come home to roost and the cycle finally turns, the Fed is going to end up having to cut rates against a backdrop of fiscal profligacy run wild, potentially undermining the currency as they ease. At that point, it wouldn’t be entirely clear who would be willing to sponsor the U.S. long end and so, there’s a sense in which what you’re seeing right now is akin to an “incubator” for eventual “vicious steepeners” (to quote Deutsche Bank’s Kocic).
But I digress. In the near-term, it seems likely that the long will find buyers at a certain point. As Bloomberg writes in a new piece, that’s the position Citi is taking:
With the longest selloff in a year stalling, Citigroup strategists Jabaz Mathai and Jason Williams say go long duration by purchasing 10-year notes at about 3 percent. They’re targeting a rally that pushes the yield down to 2.65 percent, according to a note released Thursday. They’d add to their position on a selloff up to 3.1 percent, but would stop out at a close over 3.15 percent.
And coming full circle, the above-mentioned Matthew Hornbach is sticking with his bullish call as well, saying this week that Morgan still sees 10Y yields at 2.5% by year-end.
So hell, I don’t know. But what I do know is that there’s probably not much to be divined by obsessing over 3% day in and day out and if I’m right to say that, then I was wrong to write this post.
Have a good evening.