The Fed Has Another Bond Market Conundrum

(Bloomberg View) -- Friday's lackluster U.S. jobs report fit in well with the narrative that has developed in the bond markets this year, which is lower yields for longer. The surprising rally in fixed-income assets has primarily been a function of rapidly diminishing expectations for inflation as the prospects for a boost from the Trump administration's fiscal agenda fade, oil prices sag and wages fail to respond to the tightest labor markets in a decade.

A casual look at the economy's prospects would not lend itself to an extreme bond-bullish view, but this market has been characterized by armies of doubters proven wrong time and time again as intermediate and longer maturity Treasuries failed to respond to the Federal Reserve's plan to boost interest rates three times this year. At the same time, the equity markets are regularly making new all-time new highs and corporate bond yield spreads are extremely narrow. So why can't the Fed get market rates to move higher? 

We often see bond market moves create their own momentum, as a steady one-directional move can draw in speculative players who take their cue from the charts. That's happening now in Treasuries, with Friday's weak data taking 10-year yields lower by 7 basis points through some very important technical resistance around 2.16 percent to a new low in yields for 2017 and a break below the important 200-day moving average. Those same bond charts suggest there isn't much to stop the rally until 10-year yields drop to the 1.80 percent area that prevailed before Trump's election victory.

The move on Friday was neither explosive nor fueled by high-volume, but the steady grind higher in bond prices found few willing to trade against it. Even though the Federal Reserve is still likely to raise short-term rates when policy makers meet June 14, the fourth such move in this tightening cycle, Friday's jobs report has given rise to the notion that the 100 basis points of Fed hikes could represent the completion of the cycle. The market has priced out all but a mere half a hike for the rest of 2017 and 2018, meaning that the consensus has shifted toward a “June and done” narrative when it comes to the Fed.

The market's shift toward such an abbreviated rate cycle is also supported by Fed's plan to shrink its massive $4.5 trillion balance sheet by slowly ending the reinvesting of maturing bond proceeds into new fixed-income assets. While there is uncertainty regarding the timing of the program, statements by numerous Fed officials hint that the process should begin this year. The market sees the program as a worthy substitute for that third rate hike even though the Fed has tried to separate the two. 

Many investors view the Fed under Chair Janet Yellen as innately dovish and conservative, assuming they will respond quickly to end their tightening program if the inflation data continues to come in in the weak side, risk assets such as equities and corporate bonds retreat or the economy falters. While the consensus still expects the economy to chug along and wages to stay firm, recent weakness in some sectors such as autos and the recent drop in energy prices has led to some market players saying any further hikes would be a policy mistake, with some even subscribing to the radical belief that the next Fed move will be an easing.

That is why we have seen the yield curve flatten, as short-term yields hold firm on the Fed's tough talk on rates while long-term yields drop on the notion that growth and inflation are hardly about to take off. This is the conundrum that bedeviled former Fed Chairman Alan Greenspan back in 2004 when the central bank was raising rates.The Fed's grip on the very short end of the yield curve is undeniable, but longer-dated rate expectations are not as easily controlled, especially in an economy that never seems to get into take-off speed as in prior recoveries.

The Fed has signaled that the June rate hike is still in the cards, but they have a tough task ahead of them if they still plan on at least one more by year-end, as all that liquidity created via central bank channels since the Great Recession across the globe is still hunting for yield.

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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