As recently as the start of last week it looked like the U.S. Treasury market was primed for an historic bullish breakout, with pundits forecasting a quick march lower in 10-year note yields to the 2-per-cent yield marker as inflation measures sagged, oil prices entered a bear market and disarray in Washington trashed all hopes for the Trump administration's economic agenda.
Although that bullish landscape hasn't changed much, the market has surprisingly traced out a significant 28-basis-point reversal in yields to the 2.36 per cent area and the bears are firmly in charge. Even as measures of volatility continue to plumb new lows, bearish sentiment is rapidly pervading the fixed-income market, with threats evident from hawkish central bankers, improved economic data and ominous trading patterns.
European Central Bank president Mario Draghi was the initial trigger for the reversal in bond sentiment when he hinted that faster growth in Europe could allow for both interest-rate hikes and some slowing of the blistering pace of bond purchases mapped out by the central bank. While his comments were quickly walked back by insiders maintaining that he was misinterpreted, the damage was done: Bond markets globally were hit as investors realized they faced the beginning of the end of aggressive quantitative easing programs that have kept high-quality government debt in short supply. Perhaps some of the collateral damage from Mr. Draghi's remarks were evident in today's auction of French 30-year bonds, which drew tepid demand and pressured fixed-income assets lower around the world.
Although the Federal Reserve is well ahead of its counterparts in terms of being less accommodative, policy makers have struggled at times to get across their message that they don't plan to ease up even with inflation coming up on the sluggish side. Now, they are trying a new tact, openly expressing concern for what they see as runaway asset pricing after financial conditions eased following each rate hike. This new focus allows them to proceed with their mandate to hike rates at least once more before year-end while starting the process of trimming its balance sheet assets.
And after months of disappointing economic data, growth trends look more positive. The Federal Reserve Bank of Atlanta's GDPNow index puts second-quarter GDP at a solid 2.952 per cent and third-quarter estimates are in the same neighbourhood. Those kinds of numbers would give the Fed a clear path to hike in December, even though the market has roughly 68 per cent of such a move priced in as of Wednesday. It is too early in the inter-meeting period for central bankers to try and guide the markets toward pricing in a possible September rate increase and market odds for that remain quite low at 22 per cent. The minutes of the June Federal Open Market Committee meeting released Wednesday show the Fed is prepared to begin shrinking its $4.5-trillion (U.S.) pile of Treasuries and mortgage bonds very soon – with many analysts predicting a September start. We should get more colour on the timing of the momentous taper from Fed chair Janet Yellen next week in her semi-annual testimony before Congress.
The final piece in the market's reversal has come in the form of major speculative positional shifts in Treasury futures, where leveraged traders swung toward large net long positions in 10-year contracts from a large net-short position in the first quarter. The thinking here is along the lines of whoever wanted to capitulate on their bearish positions has already done so, leaving little room for further upside from those reversing their bets. At the same time, those traders who focus on technically driven trading patterns and price levels have reversed their bullish bias as 10-year yields broke higher through key support lines in the 2.30 per cent area, a familiar battleground this year in the market's trenches. Those who believe in momentum will be sellers on further weakness in bond prices, with their chart targets going all the way back to the year-to-date highs of 2.625 per cent.
All this means that investors will be hyper-focused on Friday's U.S. jobs data, with the median estimate calling for a healthy 180,000 gain in nonfarm payrolls for June. They will pay especially close attention to the average hourly earnings data, where economists see a 0.3-per-cent gain as it may lend credence to the Fed's belief in the transitory nature of the recent weakness in the inflation data.
Scott Dorf is a columnist with Bloomberg News and managing director at Amherst Pierpont Securities.