Factors Behind Today's Perplexing Bond Rally
Tony Crescenzi
Chief Bond Market Strategist
Miller Tabak + Co., LLC
Inflation is the bond market's greatest nemesis and all indications are that the U.S. inflation rate is accelerating. This is quite clear in today's release on consumer prices and in Tuesday's release on producer prices. Yet despite these reports and other factors that might normally be expected to knock bond prices lower, U.S. Treasuries have rallied, with the yield on the 10-year T-note falling to 4.15% today from an intra-day high of 4.24% and from Monday's close of 4.19%.
As with any significant market move, there are a variety of explanations for today's Treasury rally. Some of these seem counterintuitive, which is why so many on Wall Street seem to be scratching their heads today. Nevertheless, many of the factors behind today's rally are either technical ones are factors that are not likely to have lasting influence on the bond market. In other words, the bond market rally is not likely to go far absent support from fundamentals.
Falling Dollar: This is probably one of the more perplexing factors helping the Treasury market of late. In theory, a falling dollar is bearish for the Treasury market for a variety of reasons. For starters, a falling dollar tends to push import prices higher, contributing to accelerating inflation. This has in fact been the case this year, as import prices have increased at their fastest pace in 20 years recently, owing to surge in both petroleum and non-petroleum prices (non-oil import prices are gaining at their fastest pace in about 10 years). A second reason is because the falling dollar could discourage foreign investment in the U.S., thereby reducing the demand for U.S. bonds. After all, why would foreigners buy the U.S. 10-year at 4.15% if they might lose just as much on their purchase of dollars?
While these seem to be ample reasons to expect yields to rise in the U.S. it ignores the other dynamics by which the dollar's decline can help the Treasury market and which appears to be doing so today. Specifically, the dollar's weakness against the Japanese yen is fueling speculation that the Bank of Japan will intervene in the currency market to try to stem the dollar's decline. When Japan buys dollars it invests those dollars in Treasuries (it doesn't leave the money in a checking account). Japan has intervened heavily in the currency market over the past 18 months, fearful that the falling dollar will reduce U.S. demand for Japanese exports, upon which Japan's economy depends heavily. Japan massive intervention effort has pushed its Treasury holdings up 75% to $720 billion over the past 18 months and Japan now owns 20% of all Treasuries outstanding.
Japan's Holdings of Treasuries (in billions of dollars):
With foreigner investors owing 50% of all Treasuries outstanding, their influence on the Treasury market cannot be discounted. Foreign holdings of Treasuries have increased not only because of Japan's currency intervention, but because the widening U.S. trade deficit is putting more dollars into the hands of foreign investors, who take their increased dollar reserves and recycle them back into dollar-denominated assets, such as U.S. bonds (foreign purchases of corporate bonds reached a record $44 billion in September). The recycling of dollars is a source of natural demand for Treasuries, as is the case with China, which holds a $15 billion monthly surplus with the U.S. After all, what are they to do with all this dollars?
Short-term Bearishness in Options Trading: The put/call ratios on the options for 10-year T-note futures reached a multi-year high over the past week, using the rolling 10- and 15-day averages as a gauge. Speculators began buying puts before the election and they continued to do so following the recent employment data, likely betting that the ending of uncertainties surrounding the election and renewed vigor in job hiring would weaken Treasuries. The extraordinary level of bearish options activity likely helped to prevent a larger negative response to outcome of these events as well as this week's inflation news. The short-term nature of these bets will obviously exhaust itself as a factor in the Treasury market in the coming weeks.
Heavy Corporate Bond Issuance: Market News estimates that today's issuance of new corporate bonds might reach as high as $12 billion, or about six times the normal daily level.
Today's issuance is unusually large because issuers are rushing to sell new debt ahead of the Thanksgiving week, which typically ushers in a period of very low issuance into yearend. Treasuries benefit when new supply is priced because hedges placed against new issuance in the days prior to the issuance is unwound, resulting in short-covering in Treasuries. This is of course a short-term factor and is actually negative for Treasuries in the long-run, as it both increases the amount of fixed-income supply that the Treasury market must compete against and is a sign of increased preference for corporate bonds. Moreover, because the issuance good news for the economy, it is a negative for Treasuries.
Yield Curve Trades: In recent days Federal Reserve officials have indicated that the Fed is likely to continuing raising interest rates in the months ahead. The Federal Reserve's continued resolve against inflation is contributing to a steady flattening of the yield curve, with short-term interest rates up sharply since the Fed's first rate hike in June but long-term rates lower. For example, the yield on the 3-month T-bill has increased from about 1% at the start of June to 2.12% currently, having reached its high for this year on Tuesday. Meanwhile, the yield on the 10-year T-note has fallen from a yield of 4.75% to its current level of 4.15%.
There has also been talk today of a large unwind of a trade involving German bunds, with an investor said to be selling bunds and buying Treasuries.
All of these factors are important but they lack a fundamental basis. They therefore seem unlikely to support any meaningful decline in yields from current levels. Accelerating inflation, increased competition for capital (higher stock prices), solid prospects for holiday spending, and a continuation of recent improvements in the labor market, are reasons to believe the rally won't last, unless Japan gobbles up significantly more Treasuries. |
