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Treasury Rally Should Have Peaked For Now

8 January 2019 by Mark Holman

The rally in US Treasuries since October has been almost as impressive as the sell-off in risk assets, but the capacity for this rally to continue is wearing thin, unless the data takes another sharp leg downwards.

The Federal Reserve has steadily wound back from the hawkish comments of Chair Jerome Powell on October 3 that interest rates were “nowhere near neutral”. That became “just below neutral” on November 28, before moving to the bottom end of the neutral range at the FOMC press conference in December, when we also had a comment that the central bank’s balance sheet reduction was on “autopilot”. Then on January 4, Powell said the Fed can afford to be patient on any further tightening and can alter the pace of balance sheet reduction if it’s really needed.

The sell-off in risk assets was originally triggered in October by a combination of concerns around a potential Fed policy error, a slowdown in global economic growth (a ‘coordinated economic slowdown’ as it will soon be called), and fear that the combination of these might eventually lead to recession.

Last Thursday’s shocking ISM manufacturing report of 54.1, down from 59.3 with the more forward-looking component of new orders falling a whopping 11 points from 62.1 to 51.1, seemed to confirm these fears and sent 10-year Treasury yields to 2.55%, a level not seen since this time last year. Given yields were at 3.25% in mid-October, this is a very significant move.

However, looking at what is now priced in to bond markets, we feel fresh negative impetus would be needed to keep yields this low or to push them lower.

The yield curve last week was almost flat at the 2.50% upper bound of Fed Funds all the way out to five years, with a slight inversion between two and three years. Looking more closely at the inversion, front end swaps implied a 10 basis point rate cut by the end of 2019.

This change in pricing of US Treasuries and market perception of Fed activity has literally moved from one extreme to another. Clearly Thursday’s ISM data release was worrisome for markets, but that was quickly followed on Friday by an unambiguously strong employment report, as well as a forum in Atlanta where the current Fed chair and his two predecessors poured some cold water on the growing bearish sentiment. Powell reiterated “patience” and highlighted a strong US economy, albeit with a likely slowdown from the elevated levels of growth seen in 2018, but still with robust growth that the Fed sees continuing beyond 2019 into 2020.

The current period was compared to the end of 2015 when, under Janet Yellen, the Fed hiked and was expected to hike a further four times in 2016. It actually only managed to do so once, in December 2016, as growth slowed. The Fed was patient and adapted to changing data then, just as they are talking about doing now.

A rate cut, though, is a long way off. That is a lot of poor data away from where we are now. We think the Treasury rally for now has run out of steam and too much negativity has been priced in, which is why yields have been drifting modestly higher since Friday.

On the flip side, Treasuries have once again shown that they work well as a risk-off asset, particularly now the Fed has been able to push rates higher. Given this characteristic and the likelihood of volatility in 2019, combined with a slowly softening economy and an aging cycle, there is likely to be strong demand for risk-off assets this year, which should stop Treasury yields gapping higher as they did in 2018.

Investors are likely happier now the adjustment in risk asset pricing has made valuations more compelling, but on balance they probably still hold more risk than they would like, which either makes them sellers into strength or buyers of the risk-off asset on higher yields.

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