Relentless Bond Rally Leaves Traders Wondering What They Missed

(Bloomberg) — In recent months, Priya Misra has viewed the bond rally as driven primarily by technical factors, such as market positioning that was soon to reverse. Twice, the global head of rate strategy at TD Securities advised clients to bet against the rally in Treasuries, expecting strong economic momentum and high inflation to push returns. Twice she had to give up the call as bonds continued to rise. Now she wonders whether falling interest rates point to cracks in the global economy and the possibility that the Federal Reserve is making a policy mistake by signaling plans to unwind stimulus faster than investors and traders may see fit. “We can all see why technicalities can hold us back from fair value for a while,” Misra said. “But if it stays there for two months, then you start to think it must be something fundamental here, or a big asset allocation here. It’s not just positioning because no one is blurring it. It’s a weird market.”

The bond rally, which was initially dismissed by investors and analysts as lack of fundamental support, has proved persistent. 10-year Treasury yields are on track to fall for four straight months, something they haven’t done since the start of the pandemic. They are down about 1.3% from a year-on-year high of 1.77% at the end of March, partly amid the rise of dangerous Covid-19 strains.

In addition, 10-year real yields, which are considered the market’s purest growth rates because they exclude inflation, are back below minus 1% and around the lowest level since February. The shift means the 10-year Treasury Inflation-Protected Securities auction could deliver historically low returns next week.

Break Market

The latest plunge in the cost of long-term borrowing came even after reports this week showed rising inflation and stronger-than-projected retail sales. The apparent disconnection has left some market participants scratching their heads.

“Bond traders used to worry about inflation,” said Ray Remy, co-head of fixed income at Daiwa Capital Markets America. “Somewhat alarming” inflation rates and “non-stop” treasury stocks support the widely held view that long-term yields are too low, he said.

But for him, the Fed’s bond purchases, along with its forward guidance and the advantage of US interest rates over Europe and Asia, are the main drivers of lower interest rates.

Among other possible explanations, short-covering has received a lot of attention – essentially market players foregoing reflation bets. The latest weekly survey by JPMorgan Chase & Co. found that a net 23% of customers were short on Treasuries, up from 33% in mid-June, the largest short bias since 2017.

However, the fact that the market is still leaning bearish — meaning more short-covering potential — suggests the rally isn’t over yet, said Ben Jeffery, a strategist at BMO Capital Markets. He expects 10-year yields to fall to around 1.21% in the coming weeks.

Seasonal thoughts

Seasonality is also a consideration. According to TD’s Misra, government bonds rose in July and August as corporate bond sales slowed and Japanese investors invaded. Over the past two decades, 10-year yields have fallen by an average of 4 basis points in July and 16 basis points in August.

But more broadly, investors and analysts are concerned as bond markets signal a significant slowdown in growth amid resurgent Covid-19 infections, just as rising inflation prompts central banks to cut support. While Fed Chair Jerome Powell told Congress this week that tapering bond purchases is still a “way out,” one of his colleagues said it’s time.

In a report this week titled ‘What Does the Treasury Market Know That We Don’t?’, JPMorgan strategists said yields represent economic growth of just 0.5% for the coming year, nearly 3 percentage points below their forecast.

However, the bond market’s narrative of a policy flaw or slowdown in growth is not consistent with signals from other assets, with stocks near all-time highs and corporate bond spreads at historic lows.

Misra said she’s still looking for a 10-year yield to move toward 2% by the end of the year, though she doesn’t plan to bet against Treasuries right away. “I just don’t put it on until I see a catalyst,” she said. “I don’t know what the next catalyst will be.”

what to watch

The economic calendar July 19: NAHB housing market index July 20: building permits; housing begins July 21: MBA Mortgage Applications July 22: Chicago Fed National Activity Index; jobless claims; Longer consumer comfort; leading index; existing home sales; Kansas City Fed Manufacturing Activity July 23: Markit US PMIs; 10 years TIPS year

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