People walk on Wall Street in front of the New York Stock Exchange (NYSE) on Feb. 6.Brendan McDermid/Reuters
"The sky is falling; the sky is falling!" Substitute "bond prices" for "sky" and you'll have a sense of the mood in the fixed-income market the last few months.
I won't diminish the potential bearish impact the swelling U.S. budget deficit will have on the bond market as supply surges in the months and years to come. But we don't know how much it will affect the market if there is no accompanying increase in inflation and gross domestic product. Still, that hasn't stopped people from making too much of bearish data, while ignoring a soft underbelly that challenges the bearish narratives. That's what I'm about to do.
Certainly, five increases in the federal funds rate since December 2015 and the doubling in 10-year Treasury note yields since mid-2016 would constitute a bear market by any measure, but what I suspect is coming is more of a teddy-bear market than a grizzly bear, at least based on recent statistics and hyperbolic stories throughout the press.
First, I've read, reread and read yet again articles about the deficit exploding. We knew of that danger well before the tax plan was enacted into law in December. Each report pretty much rehashes the same statistics in an attempt to explain the rise in volatility and interest rates. In reality, few dollars have been added to the deficit projections. When old news is rehashed as new information it can arouse emotions without adding more to the fundamental picture.
Second, there's the selective use of data events, which I have also used to my advantage. Take the consumer price index. A greater-than-expected increase on Wednesday provoked a sharp selloff in the bond market and was followed by press reports of inflation coming back and, along with a weak retail sales report that same day, led to the term "stagflation" being thrown around.
But here's the thing: January is a notoriously bad month for inflation. On average, it shows the second-highest monthly increase over the course of a given year and is the highest for the core figure, which excludes food and energy. This particular January had very cold conditions, which may help explain that two of the largest contributors to the gain in the CPI were energy and apparel. In other words, from an historical perspective we can expect month-over-month gains to ease.
Another weather quirk can be seen in the January employment report. While the 200,000 increase in jobs was not too threatening, the surge in wages caught the attention of the bears and is cited along with the CPI report as a reason to dump bonds. It's not so simple. A lot of people were not at work due to bad weather, and maybe because of the flu, which explains the dip in hours worked. The 0.3-per-cent gain in average hourly earnings was skewed to a small segment of the workforce, the upper echelon. Production and non-supervisory folks, who account for 80 per cent of the workforce, saw a more modest increase of 0.1 per cent. These are the people who couldn't get to work due to bad weather and whose hours worked dipped to 34.3 from 34.5 in December.
It's also important to understand that the CPI data took a toll on inflation-adjusted earnings. Real average weekly earnings fell 0.8 percent in January, and real average hourly earnings dropped 0.2 per cent. That might help explain the weak retail sales data that were largely ignored by the bond market.
Then there's an empirical measure of sentiment in various forms, price action not being the least of them. One of the best contrarian indicators -- and one that has worked for me for almost 30 years -- is the Daily Sentiment Index. This is a survey of small traders in actively traded futures put out by Network Press. Essentially, the survey asks if you are bullish on a given commodity. When the index falls below 20 per cent it means that more than 80 per cent of the "market" is bearish. And when the market in question becomes that oversold, it typically marks an inflection point and foreshadows an impending reversal. The DSI for 10-year note futures slid under 12 per cent a few days ago and remains a very oversold 14 per cent, begging the question of who is left to be bearish.
So is Chicken Little right to run around yelling the sky is falling? At the end of 2017 I wrote that I expected 10-year yields to rise to around 2.85 per cent to 2.95 percent, which they've done rather earlier than I expected. The evidence suggests yields at those levels provide value, at least in the near term. However, there's a chance yields could probe the 3-per-cent to 3.25-per-cent range at some point toward the middle of the year as the sheer weight of increased issuance spooks both the Fed, due to the added stimulus of the tax plan, and the marketplace that has to buy many more bonds. Yields teasing into that range should be enough to boost the dollar and prove ample competition with a richly valued equity market.
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David Ader is chief macro strategist at Informa Financial Intelligence. He was the No. 1 ranked U.S. government bond strategist by Institutional Investor magazine for 10 years.