No fear of the Fed

I have been offered 5 to 1 odds last week, for a bet that 10 year US rates will hit 2.70% before they go to 2%. Notwithstanding that I am absolutely conscious that this thing could remain volatile for some time to come, depending on what the Fed’s communication policy will be this year, I took the bet. The view of this space remains unchanged from its piece that was published in The Treasurer magazine 2 weeks before the US election.

And as most of you know, it goes like this… Trump’s win would cause a massive correction in bond markets in general but 10 year rates would hit resistance at around the 2.50% mark, from where a gradual retreat towards 2% is to be expected again. Why? Whatever kind of reflation trade Trump promised during the campaign got priced in, and now the market is slowly getting cold feet on how much he will eventually be able to do.

Then, we must not forget that the world’s excess liquidity hasn’t gone away. Pension and life money have been suffering for so long, getting sick of piling ever more funds into the risk-free at a 1% yield handle, and they have only been waiting for a chance like this. It is kind of providing a liberating breather for them. For some, a 30 year yield above 3% is like a god-sent.

Then, not even the Trump phenomenon will be able to kill off a 30 year bull market overnight, one that is absolutely intact by the way. It is driven by much bigger forces than a president to announce tax cuts and public work spending at work. As I have pointed out on numerous occasions, demographics is destiny, and the Western world’s bond markets have been and will be driven largely by ageing and declining populations.

Then, for this correction to gain momentum the Fed would have to substantially change. To be sure, Janet Yellen has hardened her rhetoric this year, but in the end she simply cannot commit to a course of action without applying her tried and tested data dependency clause. Rate hikes were appropriate if the economy improved, or so she keeps saying. Does that not remind of last year? And so, will there really be 3 hikes in 2017?

You have doubts? Well, you heard her testifying before Congress last Wednesday. She did say that she believed the Fed was coming very close to achieving its objectives of maximising employment and price stability, but she also conceded that economic growth had been quite disappointing. Despite the few hawkish buzzwords it does not appear that her so far disastrous communication policy will change.

I guess Yellen has one more chance to give what the market would consider due guidance, at her speech this coming Friday before the Fed enters the self-imposed silent period in the run-up to the March rate decision. If all of a sudden she chose to be a lot more granular and talk up a hike sooner than people now expect, then rates could bounce. But why should she deviate from her script? No reason really…

Then, the Trump administration’s performance is not that far behind her’s, at least so far. How is America being made great again? Spending on infrastructure that runs counter to Trump’s vision of bringing the national debt down? Tax cuts that may not see the light of day before 2018, as the debt ceiling will likely be a material issue before summer? A continuing stand-off between the presidency and the Deep State?

Well, if Trump pulls it off to get his infrastructure financed off-balance sheet to a large part, i.e. letting take the likes of Japan’s pension system a chunk of the debt, he might get closer to the impossible-looking split. And such stunts will not just reflect well on him as a dealmaker but also go easy on the budget, to an extent that the anticipated deficit spending might look much less horrendous than widely thought.

Then, there is the issue of what constitutes a safe haven these days, and all that might remain in the world is the Treasury market. All of Europe is already in outright panic mode over the election bonanza coming this year. It will commence shortly in The Netherlands, on March 15, to continue in France in May and Germany in September, possibly Italy squeezed in between. But we may not have seen anything yet.

Investors sure aren’t being complacent. They are diligently driving 2 year Bund yields through the ground last week, to -95bp!, paying what they would consider an insurance premium for a hedge against a eurozone break-up. But you wait until people more widely recognise the consequences of the Target2 mechanism, something this space has been commenting on for years and which will go nothing short of nuclear in case of a country leaving.

The truth is that the Treasury market is not being impressed with any form hawkishness produced by either Fed or commentators. On the contrary, it is taking matters into its own hands and has rallied late last week to convincingly close at 2.31% and confirming a trend of lower highs and lower lows ever since we hit the intra-day high of 2.64% early December, likely gearing up for an eventual break on the down.

Certainly, if macro numbers don’t improve significantly, which is not to be expected, the March Fed action doesn’t materialise, and places like Europe go haywire, yields will be heading lower. Whether we will hit the 2% threshold as a consequence of this move remains to be seen, but we should expect a constructive performance of the rates market in coming months and possibly the entire year.