The Daily Prophet: Bond Market Breaks Out, but in a Bad Way

Connecting the dots in global markets.

Since late September, the yield on the benchmark 10-year Treasury note has fluctuated in a relatively tight range of about 2.30 percent to 2.42 percent or so. But now, without warning, yields are breaking out above the upper end of the range, an event that potentially has implications for markets around the world.

The 10-year yield shot up as much as 11.7 basis points on Monday and Tuesday, to as high as 2.47 percent, in the biggest two-day increase since January. No one is exactly sure what sparked the move. Some point to large trades in the futures market, but it wouldn't be far-fetched to conclude that traders are finally facing up to the fact that the lost revenue from the Republican tax plan will need to be made up with lots of debt. Government debt sales are set to more than double in 2018, lifting net issuance to $1.3 trillion, the most since 2010, according to JPMorgan estimates. With the Federal Reserve shrinking its bond holdings and deficits poised to swell even before taking into account the tax overhaul, all signs point to higher financing costs, according to Bloomberg News' Liz Capo McCormick.

With the Fed pulling back and issuance surging, Credit Suisse calculates that the percentage of new debt price-sensitive buyers will be asked to absorb will rise to about 60 percent by the end of 2019, from 54 percent now. That would be their biggest share since the early 2000s, McCormick reports. “There should be some overall repricing of yields higher, albeit modestly, on the back of the rising supply picture,” Subadra Rajappa, head of U.S. rates strategy at Societe Generale, told Bloomberg News.

Stocks were broadly lower Tuesday, with the Nasdaq Composite Index falling the most in two weeks. For those worried that valuations are at nosebleed levels, and not even corporate tax cuts justify them, here's another metric sure to induce more anxiety: At Monday’s close, 30 percent of the companies in the S&P 500 Index traded above their average analyst price target, data compiled by Strategas Research Partners show. In other words, stocks already reached levels they’re expected to attain 12 months from now, according to Bloomberg News' Lu Wang. Rest assured, it's not as bad as it sounds. Rather than a sign of a frothy market, Strategas' head of technical analysis, Chris Verrone, says the gap shows analysts are too conservative with their estimates. “Believe it or not, this has historically been a bullish signal, consistent with above-average forward returns and positive hit rates,” Verrone wrote in a research note. “The sell-side analysts are behind the curve and likely have to raise numbers.” There were 12 instances since 2002 when a big proportion of stocks rose above their average price target. The S&P 500 posted positive returns 81 percent of the time three months later, with gains averaging 4.2 percent.

Sky-high returns and surge of inflows have put emerging markets on a narrow precipice. That assessment doesn't come from another worrywart ranting about "complacency," but from the sober-minded International Monetary Fund. The Washington-based organization is warning that 2018 could mark the tipping point for emerging-market bond funds sitting on the biggest annual inflows since the financial crisis, according to Bloomberg News' Natasha Doff. A pickup in global growth that pulled Russia, Argentina and Brazil out of recession also helped to buoy sentiment, driving returns of 19 percent since the end of 2015. Monetary policy normalization will reduce inflows to emerging-market funds by $70 billion over the next two years, according to IMF estimates. The guardian of financial stability warned that diminished access to foreign capital could also make it more challenging for economies in the developing world to finance deficits and roll over debt.

The worst-performing currency in the world on Tuesday was the Mexican peso, which weakened as much as 0.83 percennt. Traders beat the currency down following a report that the Finance Ministry had funneled money to campaigns for politicians from the ruling party. The former finance minister of Chihuahua state, Jaime Herrera Corral, gave testimony on July 1 that the Finance Ministry had channeled as much as 250 million pesos ($13 million) to the PRI party in 2016, Reforma reported. The peso was also buffeted by Banxico governor Alejandro Diaz de Leon’s comments to Milenio TV that uncertainty surrounding Nafta renegotiations would dent the currency, according to Bloomberg News' Justin Villamil. Support for the currency among strategists has been waning since September. They now see the currency trading at 19 per dollar next quarter, compared with forecasts of 18.2 three months ago, according to data compiled by Bloomberg.

World coffee stockpiles for the 2017-2018 season are poised to drop to the lowest in five years as global demand remains buoyant, according to Bloomberg News' Marvin G. Perez. Consumption is forecast to climb for a seventh straight year, the best streak in records going back to 1961, U.S. Department of Agriculture data show. Given the fundamentals for the season, which ends on Sept. 30 in most countries, the risk-reward of adding more short bets “is not worth it,” said Hernando de la Roche, a senior vice president for INTL FCStone in Miami. Robusta and arabica-coffee futures have been among this year’s worst-performing major commodities tracked by Bloomberg, with price declines exceeding 10 percent.

Global currency traders will be keeping a close eye on Sweden on Wednesday as policy makers at the Riksbank meet. While no one expects them to raise interest rates, they are widely expected to declare victory against deflation and end the bank's bond-purchase program. But to keep the krone from soaring on the news, the Riksbank is likely to send a very dovish message, according to Bloomberg News' Jonas Bergman. One way the central bank will do that is by saying that instead of an abrupt an exit from quantitative easing, it will keep expanding its balance sheet next year by reinvesting interest payments from its massive bond holdings into new securities. Bergman reports that the bank may also pre-invest some of the almost 50 billion kronor ($6 billion) it owns of a security maturing in 2019. That would keep stimulus close to this year’s level, help prevent an appreciation in the krona and stabilize inflation.

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