Bond Market Trends Move More in Favor of the Bears

(Bloomberg View) -- Traders of U.S. Treasuries thought they had glimpsed the long-awaited breakout in yields last week, as all the fundamental, technical and political drivers lined up for an upward move in the U.S. interest-rate structure. That was until the news on Friday that President Donald Trump's former national security adviser, Michael Flynn, pleaded guilty to lying to FBI agents. Suddenly, the best-laid plans for trading a bear market went awry.

The current milieu of rates trading has become a three-dimensional game of chess, with political shock waves added to the usual economic and bond supply narratives. Most of the puzzle pieces fit into an eventual rise in U.S. rates, but as we saw last week, market nervousness over the Washington scandals can slow -- or even stop -- that path. Ten-year Treasury yields have been locked into a very narrow band for most of the year, and have been confined to an even narrower range more recently.

November was one of the least volatile months in history, with yields trading in an 11 basis-point band. Traders queued up to buy when yields reached about 2.40 percent, and sold near the 2.30 percent level. Traders who look at trading patterns to divine future prices will see a break of this range as a “go-with” technical signal, and for now the odds of a break above the higher end of the range look like a better bet, as 10-year yields touched 2.42 percent in overnight trading.

Of course, the market is not defined by just the 10-year maturity, although it gets most of the media focus as the global sovereign debt benchmark. Perhaps more notable is the well-established trend toward higher yields in shorter maturities. Yields on five-year Treasuries reached 2.17 percent last week, which was not only a new high for the year, but the highest since early 2011. The steady rise in shorter-term yields is being driven by a resolute Federal Reserve, which has surprised the bond bulls by sticking with their plan to raise interest rates three times in 2018, following one more this year when policy makers meet next week. That would be the fifth increase of the current cycle.

The bear case for bonds centers on the idea that recent robust economic growth will power wage gains -- and ultimately inflation -- amid a very tight labor market. With the prospect that the unemployment rate will drop to well below 4 percent by the middle of 2018 from 4.1 percent currently, the argument is that wage growth will only get stronger. This week ends with the monthly jobs report for November and the consensus is calling for another solid gain of 200,000 in non-farm payrolls. More importantly, average hourly earnings are seen rising 2.7 percent from a year ago, above the average gain of 2.2 percent of the past five years. 

While we have certainly not heard the end of Special Counsel Robert Mueller's investigation into Russian meddling in the U.S. election, the underlying negatives for bond prices will only get stronger as the Fed hikes rates, the monthly jobs report continues to show strength in the labor market, and, most importantly, the tax bill progresses toward passage. Against this backdrop, the Fed is poised to accelerate its reversal of its quantitative easing measures by shrinking its $4.44 trillion balance sheet. With the central bank reinvesting less of the proceeds from its maturing bond holdings back into the market, the burden of funding the growing U.S. budget deficit due to the tax cuts will increasingly fall on investors.

Estimates are that the U.S. Treasury will increase its net borrowing by more than 50 percent for next year. This comes as the European Central Bank is also likely to begin its own balance-sheet tapering program, cutting its monthly bond purchases to 30 billion euros ($35.5 billion) from 60 billion. The central-bank-induced bond bubble may start to deflate. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Scott Dorf is a managing director at Amherst Pierpont Securities. He has been selling and trading U.S. Treasuries for more than 30 years.

To contact the author of this story: Scott Dorf at sdorf7@bloomberg.net.

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net.

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