Gentlemen Prefer Bonds

The big story revolves around US bonds, which have fallen since May pushing yields up some 120 bps. As all creatures great and small are priced off the almighty Treasury Note, the continued surge in yields is having dire implications for other asset classes. The first line of casualties has consisted of emerging markets currencies, of which at least the Turkish Lira and Indian Rupee have fallen to all-time lows against the Dollar. One bond to rule them all, one bond to find them, one bond to bring them all and in the darkness bind them.

Alas, long term yields should be going up as the US recovery – albeit modest – continues. Interest rates are pro-cyclical, i.e. they move in the same direction as the business cycle. But, but… is this too far, too fast, just too darn furious? US industrial production – our best proxy of GDP – (see Exhibit 1) has a ways to go before we are back on what economists judge to be trend growth, i.e. the rate of growth that does not spark inflationary forces. The US is stuck in one of the most anemic recoveries since WW II.

 

 

In Exhibit 2 we provide context by extracting the illustrated 10 yr. yield spikes from the post oil shock era. Exhibit 3 plots their trajectories as well as maximal and minimal histories. The present rate path in dark blue maps into the higher end of these bond spikes, although its speed is not unprecedented.

Abstracting from a large number of caveats, such rapid rises in long term rates are unsettling especially when one conditions on the sluggishness of economic activity. There are really two interpretations (aren’t there always?)… either the market is right or it has overreacted. If it is right, then a benevolent interpretation is that it is discounting an acceleration of US economic growth.

If one is inclined to lean on the side of continued economic sluggishness then the bond market has overreacted and yields have risen too far. We should see bond yields correct by coming down or stabilizing before continuing their longer-run trend upwards at a more moderate pace.

A focal point is the FOMC meeting on the 18th of September. Not because it makes any material difference whether the Fed shaves off 15 billion from monthly purchases, but because at some juncture we all decided that the market pulse beats to the rhythm of Fed meets. Although Fed policy is a function of labour market data, it would be naïve to think that bond markets don’t enter the Fed’s reaction function implicitly.

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