As the momentum of the bond rally wanes, the argument for engaging in short positions on Treasuries is growing more persuasive. The realm of the bond market, which US political advisor James Carville envisioned as his desired afterlife, is on the verge of becoming formidable once more.
The upward surge experienced since the lows of last October is losing momentum, and there is now a multitude of compelling factors indicating that longer-term Treasuries are poised to decline in value in the near future. Consequently, this decline would result in higher yields and provide support to the yield curve:
- Global financial conditions are easing
- Excess liquidity is rising
- Inflation is becoming entrenched
- An increasingly precarious fiscal situation
- Declining overseas demand for USTs
- An expected jump in issuance when the debt ceiling is resolved
Let’s begin by addressing the looming issue of the debt ceiling.
During the debt-ceiling crises of 2011 and 2013, bond yields predominantly experienced a decline. Paradoxically, despite being the focal point of heightened risk, Treasuries served as the sole safe-haven asset in a risk-averse climate.
Although we might witness a similar knee-jerk reaction on this occasion, it should be viewed merely as an opportunity to sell. Net Treasury issuance has significantly slowed in anticipation of the approaching debt-ceiling deadline. However, if a resolution is reached (which remains more likely than not), Treasury issuance would swiftly accelerate, resulting in an excess supply that would exert downward pressure on prices.
Beyond the weight of the debt-ceiling issue, we find ourselves at a crucial juncture in the economic cycle. It is not only the United States but also the global landscape that is witnessing a peak in short-term interest rates. This trend is effectively captured by the Global Financial Tightness Indicator (GFTI), which reflects the collective tightening actions of G20 central banks. The GFTI has been on an upward trajectory, and this trend is expected to gather momentum as central banks increasingly shift their focus from inflation concerns to fostering economic growth (despite any contradictory statements they may currently make – after all, words come easy).
As depicted in the accompanying chart, movements in the GFTI tend to precede shifts in the US 10-year yield.
At first glance, it may appear counter-intuitive that peaking short-term rates would result in higher longer-term yields. However, the relationship between these variables indicates that once global interest rates peak, the market can factor in an anticipated cyclical upturn for the US economy. This optimistic outlook is then reflected in higher long-term yields at present.
We can observe a similar indication of a yield upturn when examining excess liquidity.
Excess liquidity refers to the disparity between the growth of actual money supply and economic development, and it is currently showing signs of an upward trend. During such periods, investors tend to favour riskier assets, such as stocks, in order to fully leverage favourable liquidity conditions, thereby diverting attention away from bonds.
The preference for equities over bonds may be further amplified during this economic cycle due to persistent and elevated inflation. Traditionally, equities have been considered better inflation hedges than bonds, although this perception is not entirely accurate as neither asset class is ideal for hedging against inflation.
Nevertheless, the prevailing perception alone can be sufficient to maintain support for equities relative to bonds, at least initially. This trend may already be underway, given that equities have shown relative resilience while bonds have experienced a lacklustre rally, despite increasingly worrisome signs of an economic downturn. The spectre of inflation serves as a reminder that this downturn will not be an ordinary one.
In fact, bonds have yet to fully incorporate the embedded inflationary pressures that are expected to materialize once the current disinflationary trend subsides. The term premium, a measure of the extra yield bondholders demands to lend money, has remained remarkably calm in this cycle, but it is unlikely to remain so. Rising inflation expectations serve as a warning signal that bond investors may soon require additional yield as compensation for lending their funds.
The debt ceiling issue has brought attention to the fiscal state of the United States. It is probable that the issue will be resolved by extending the debt limit, but this should not divert our attention from the fact that the US, along with several other developed countries, is heavily dependent on borrowing and this reliance is growing.
At present, the US budget deficit stands at 8% of GDP, surpassing that of any other major nation, and significantly exceeding the levels seen prior to previous economic downturns.
Regardless of their safe-haven status, lenders to the United States are growing increasingly concerned about the deteriorating fiscal outlook of the country. This wariness is leading them to be more cautious about holding significant amounts of US Treasuries. Foreign reserve holders have started diversifying their holdings, and the elevated short-term rates have resulted in higher foreign exchange hedging costs, deterring buyers like Japan.
Those anticipating a substantial rise in USTs driven by short-covering may be disappointed. While Commitment of Traders’ positioning indicates a significant net short position, when standardized, it appears less extreme. A more comprehensive measure that considers the inferred positioning of macro funds and commodity trading advisors (CTAs), along with insights from JP Morgan’s Client Survey, suggests a short position, but not at levels that would imply an imminent aggressive short-covering rally.
The recent sluggishness in the rally following the moderately softer inflation report on Wednesday indicates a shift in momentum. The bond market may once again exhibit the intimidating qualities that James Carville admired, instilling a sense of unease among market participants.