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Why Bond Bears Are Poised to Come Out of Hibernation...Again

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  • Four arguments in favor of higher U.S. Treasury yields
  • Fed’s balance sheet, positive data, better yield, growth

A springtime for shorts?

Besieged Treasury bears may finally be set for a winning streak in the world’s largest bond market. Strategists are citing an under-pricing of inflation in the U.S. economy, waning foreign demand and a bid by the Federal Reserve to tighten its monetary stance at a faster pace than markets anticipate.

“The next two months will be more threatening for duration longs as data holds up well, political risk in Europe ebbs, and investors refocus on progressive central bank exits from easy money,” strategists at Societe Generale SA led by Ciaran O’Hagan wrote in a note. “And therein lies the potential for a surprise to upset the ‘sleeping beast,’ an overly complacent bond market.”

“Lower bond yields and stronger growth momentum give us a good entry point into a more aggressive short-duration position in developed markets,” strategists at JPMorgan Chase & Co. led by Jan Loeys wrote in a note. They project the 10-year Treasury will rise to 2.7 percent in June and finish the year at 3 percent.

Analysts at boutique research firm CrossBorder Capital Ltd. are more bearish, expecting the benchmark yield to test 4 percent within the next 12 to 18 months amid capital outflows from China and Europe.

Here’s four arguments in favor of the bears:

Fed’s Balance Sheet

Last week should have been a win for bond bears after Fed minutes suggested it would likely phase out of the practice of reinvesting proceeds of maturing securities held on its balance sheet at the end of this year, a move that will remove a big monetary backstop in debt markets.

Speculation the Fed may delay increasing short-term borrowing costs spurred a decline in 2018 interest-rate forwards, even as June rate-hike odds edged higher. Markets may have gotten the wrong message: there’s a high bar to clear before the Fed postpones raising rates, according to analysts at TD Securities.

“The market may be underpricing the pace of hikes in the near term, and rates will move higher as the Fed begins to communicate the case for more hikes,” fixed-income strategists led by Priya Misra wrote in a note. They suggest a delay in the tightening cycle would kick in only if financial conditions tightened quickly.

As the market prices in the Fed’s unwind, it may trigger a rise in the 10-year term premium, a measure of the extra compensation investors demand to hold longer-term instruments over short-dated obligations, according to Bank of America Merrill Lynch strategists. A pickup in Treasury issuance and a rising term premium -- combined with rising long-dated mortgage costs -- are set to trigger a steepening of the five- to 10-year yield curve and increase volatility, analysts said.

Bullish Data

While equity markets have cheered strong survey-based measures of consumer and business confidence, bond markets have focused squarely on the negatives: job growth lost steam in March and U.S. consumer spending rose less than forecast in February. Still, broad-based measures of consumption are strong and the slack in the labor market is much-diminished, suggesting it’s unlikely U.S. growth will cool this quarter, according to analysts. That’s given JPMorgan confidence to stick to its forecast that the U.S. economy will grow 3 percent this quarter.

Yield Advantage

Foreign selling of U.S. Treasuries may take center stage in the coming months because returns from U.S. obligations in Europe and Japan have fallen when including currency-hedging costs, while the yields on offer on government debt closer to home have risen.

Financial Conditions

Analysts from Goldman Sachs Group Inc. to Morgan Stanley foresee the U.S. central bank striking a more hawkish stance in the coming months to engineer a tightening in financial conditions. This would be in reaction to the risk of above-trend growth at a time when employment and inflation are close to the Fed’s target.

“The robustness of the recovery, and emerging discomfort with some of the asset price developments they have generated, has led the Fed to shift their focus to the longer end,” wrote Erik Nielsen, chief economist at UniCredit SpA in London. “I don’t know why fixed-income markets haven’t reacted so far, but they will; central banks have all the tools available to steepen the curves when that’s what they want.”

The counterpoint to the bearish projections comes from Deutsche Bank AG strategists. They see a lack of fiscal action and signs of soft economic data conspiring to postpone the bear market in bonds, projecting fair value for the 10-year benchmark at 2.25 percent.

“The bear market we expected to continue through 2017 seems to be on hold mainly due to the lack of progress on structural tax reform and we do not expect that to change anytime soon,” strategists led by Dominic Konstam write.

(Adds CrossBorder Capital Ltd. projection for Treasuries in fourth paragraph.)
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