For several years now the major driver—at least as measured by financial analysts—in nearly all financial markets, not just Treasuries, has been expectations on movement by the U.S. Federal Reserve and its policy making open markets committee (FOMC). Not only is each Fed meeting hotly anticipated, but every speech by a Fed governor is parsed for hints as to the direction they are leaning and every economic report released is measured as to its impact on Fed policy.
This is odd as the Fed is firmly on record as to the cautiousness of its approach, and a simple observation reveals that the Fed is moving at a snail’s pace. It is evidence that the Fed appears to be the only game in town, at least until after the election, which is expected to produce a new administration that will be able to get something done on the fiscal end.
Despite this, the market has priced in the long anticipated second tightening for its December meeting. The Fed may have wisely silenced the chatter with its September announcement that while standing pat, indicated a tightening would happen before year-end as three voting members called for in September. “It does seem to me that a December tightening is a done deal,” says Andrew Wilkinson, chief market analyst for Interactive Brokers.
But what impact will this have on the long end of the curve? Not much.
“Assuming it is in December, you are going to have one increase in 2015 and one in 2016. By now most market participants have concluded that the Fed’s message of ‘lower for longer’ is still going to remain as an accommodative tightening cycle,” Wilkinson says. “I am not sure how much higher 10-years yields will go in the knowledge that there is going to be a tightening because right now it stands to reason that there will be one tightening in 2017. Most people understand the environment the Fed is working in now, rather than expecting the pace of tightening to pick up some.”
While the end of the now 35-year bull market in bonds is inevitable, it may not be soon and will take more than a yearly quarter point tightening to move it.
“It is actually easier to argue for lower yields in response to monetary tightening because we are now in this mode of one and done. If there is a second increase in December people will ask, ‘When is the next one?’” Wilkinson says. “As time goes on and data continues to flip between strength and weakness, then it is going to become more difficult to argue for a string of rate increases, which is why the 10- and 30-year (yield) will probably remain low. He adds, “There is no reason to believe the Eurozone is going to do any better any time soon. The global demand situation does not appear to be moving the needle.”
When gauging where the Fed can go with short-term rates and where long-term rates may move, it is important not to look at it in a vacuum or through historical norms but in relation to global rates. The Bank of Japan and the European Central Bank (ECB) have moved some rates into negative territory. This means that U.S. Treasuries can continue to rise (yields fall) and still be in high demand.
“Even if the Fed hikes in November (or December), you will probably see some bonds selling, but the bond bull market is not over,” says Jason Rotman partner at Lido Isle Advisors. “There is major support in the long bond at the 160 area; we may try and complete the pattern but once we are at low 160s we will see some buyers (see “Double bottom,” below)."
“One of the very powerful tools that the Fed has in its armory is forward guidance and it is also embodied in the Summary of Economic Projection,” Wilkinson says. “I argued for a long time that they would use the SEP as a policy tool to drive down people’s expectations of the short-term rates. That has been borne out because of two reasons: One is that they have the FOMC members compiling the reports responding to the data, which is something people accused them of not doing, [and the other is that] they softened their projections going forward. That whole part of the dot plot has softened massively.”
He noted that expectations in the last year have gone from four moves to two and now one. “Next year there is a chance there will only be one,” he adds.
The market has been waiting so long for a real tightening regime to occur that it may have forgotten that this bull market in bonds has survived several tightening regimes — real ones like in the mid-2000s when the Fed raised rates a quarter percent for 17 consecutive meetings, and also in 1994-95 when the Fed raised rates 3% within a 12-month period. Currently, they have been wringing their hands a full year over pulling the trigger on one 25-basis point increase (see “Tighten,” right).
“Past tightening cycles did not reverse bonds’ 35-year rally,” WIlkinson says. “Even after a couple of [moves] the impact will all be on the front end, a flattening of the curve. Even a tightening cycle — because it is not as big as everyone thought — can’t break this downtrend. Look at 10-year yields and look at the alternatives around the world, they are also negative.”
Rotman adds, “The Fed has no reason to be aggressive. This is not necessarily a time to buy bonds, it is going to go a couple [handles lower] and then you are going to see some high-level buyers grabbing that higher yield and being excited about that because a lot of the other bonds are negative and the stock market is stagnant. So after that move down they may see a rally going into Q1.”
But even if bonds top out, they may not reverse.
“If the bond market rolls over putting in a top and long-term rates can put in a bottom, it doesn’t mean that rates need to go through the roof, it just means they don’t go lower,” says Jamie Saettele, senior technical strategist for Daily FX. “You could be stuck in a period were rates are low for a very long time. Just because they stop going down doesn’t mean they can’t stay down. The question is where is the risk on the long bond, and it is certainly not higher.”
Because the bull market has lasted so long and has gone so far, Saettele says the July high may be a top. However, Saettele points out that the long bull market can be split into two equal 17-year (205-months to be precise) moves separated by one large correction (see “Bond top: Here or near?” below).
Cyclical traders like to point out that major turning points often correspond with news events that provide fundamental cover for the move. While the long-term cycle points to the first or second quarter of 2017, the July high occurred following what could be seen as a blow-off top reaction to the Brexit vote on June 24. “The news event that is really close to the top of the bonds is Brexit. You had an absolute frenzy of a bond rally to the highs, your last-ditch capitulation effort —you top on news with a bang; they say that the bell doesn’t ring at the top, the bell rang big time,” Saettele says.
“[Technicals indicate] we are going to make the top in February 2017. But we just had a quarterly reversal in the bond market, so from a trading perspective I would say it is best to be a bear in the bonds at these levels,” Saettele says. “It doesn’t mean that they can’t go higher, they can. If they do I would be looking to short in February, but how many months away is February, not very far, especially when considering a 35-year trend.”
Eerily corresponding with the Gann-inspired technical top is the Cycle Projection Oscillator (CPO), a complex technical tool that filters multiple cycles from historical data. The CPO has been adept at spotting major cycle turning points and indicates that bond yields will bottom in February (see “Major top/bottom,” below).
The problem, especially for technical traders, is that the three-decade plus Treasury move is so large that the corresponding corrections are huge.
“My new range [in the 30-year] is topping out at 170-170-08; I’m bullish but I don’t have strong technical reasons other than the trend is still solidly bullish,” says long-time technical analyst Steve Orfanos, founder of Orftech. “Everybody wants to be bearish. I am a little concerned because you already have seen a big move.”
Orfanos points out that from early July to the middle of September the long bond dropped 11 handles. “That is a huge move. The short-term trend is bearish. Until you get above 170, we will continue to grind lower in a range,” he says.
The problem is no technical level has been breached, or would be challenged for several more points (see “Breaking point,” below). He sees support at the low 160s. “I’m still bullish, it will drift higher for the next five six months,” Orfanos says.
“You can make the argument that when the Fed tightens, if only once, that the yield curve will flatten,” Wilkinson says. “Is it a Fed tightening or is it a hiccup to global growth. I don’t think the market is in any mood to make the assumption that it is time be ready for the next one.”
Wilkinson doesn’t foresee growth and inflation forcing the hand of the Fed or any other central bank for that matter.
“It seems to me that yields are trapped probably under 2% (10-year) for all of 2017. It would take one of two things to create a breach of the 2016 low (in the 10-year T-Note), which is 137, and it could be a shock to global growth or more aggressive Fed tightening.”
For that reason, no one is seeing the end to the bull market, or at least a major reversal.
And as we previously mentioned, with quantitative easing rates going negative globally, yields greater than 1% are downright generous.
“I would agree with the argument that low and negative foreign sovereign rates and more recent additions to balance sheets is a prop for Treasuries and has distorted the ability of the futures markets to price expected rates,” says Martin McGuire, managing director market strategies TJM Investments. “People are willing to take less as U.S. yields are relatively high.”
Wilkinson adds, “If you look at the euribor, it is trading at negative yields out to 2021. That is absolutely shocking. With the bund yield negative — just do the math — that implies negative short-term rates for the longest time. I don’t think there is going to be a massive shift in the established range for interest rates going forward.
“The [idea] of someone investing €100 and receiving €99 at maturity makes very little economic sense to carry on investing that way,” Wilkinson says. ”That entire five-year euribor strip is negative, I can’t imagine that becoming a big play, to sell those front ends and get the 10-year T-Note area out of negative territory because it is becoming unfashionable.”
Wilkinson notes that even some corporate bonds have gone negative and though it doesn’t make sense to earn negative yields, some investors are duty bound to maintain duration in their portfolios and have no alternative.
Central Banks Rule
This all comes back to the huge growth in influence of central banks since the 2008 credit crisis. Some analysts see promising signs of a retreat.
“The last couple of meetings, the Bank of Japan refrained from providing additional support. Following that, the ECB didn’t extend its duration of QE program. These were two central banks refraining from further stimulus,” McGuire says. “We are entering a new regime where central banks are wondering what the benefit is to increasing their portfolio of securities and or the value of extremely lower and negative policy rates.”
While welcome signs of restraint, McGuire adds, “If you allow any institution a wide berth, it is difficult for that institution to give up those privileges. They would have a tendency to continue to want to be active.”
Of course the main driver is growth, which remains moderate in the United States and nearly non-existent in the rest of the Western world. Until that changes bonds will remain elevated, yields depressed and central banks active.
You would expect them to be less active if global growth found a more sustained moderate growth rate.