Traders Wrestle Control of the Bond Market Back from the Fed

The Trump reflation boom trade is coming to a messy end.

Markets back in charge.

Photographer: Carl Court/Getty Images

It’s hard to believe that it was only one month ago that the Federal Reserve decided to take over the bond market from the always skeptical traders by trotting numerous governors all with the same unequivocal message: There is the chance of an interest-rate increase at every policy meeting.

There was no room for interpretation. Not only would the Fed hike rates in March, but policy makers really meant it this time when they said bond traders should brace for three increases before the year was out. Bonds sold off as it became clear that the Fed would finally start leading the market instead of following it.

Fast forward to today, and the markets are again thumbing their noses at the Fed and its forecasts for a stronger economy to go along with three rate hikes before the year is out. A lethal mix of multiple geopolitical risks, weak inflation data, waning confidence in the Trump administration’s ability to push through pro-growth initiatives, and a breakout from recent trading ranges have combined to erase much of the Fed’s careful handiwork. Once again, the central bank is left looking too optimistic.

While the geopolitical flare-ups in Syria and North Korea may already be fading from the headlines, bond investors still won’t sell into this powerful rally. That’s because they fear a Trump-style surprise in the French election, with the first round slated for Sunday. The polling has been swinging unpredictably, and the markets fears the destabilizing risk of a victory by the far-right National Front’s Marine Le Pen, who favors taking France out of the euro zone.

While keeping an eye on global instability, bond traders have been inundated with signs that the Trump reflation boom trade is coming to a messy end. The most obvious signal comes from Treasury Inflation-Protected Securities, where five-year breakeven rates went from 1.70 percent following the November election to 2.07 percent in March, only to crash back to 1.75 percent this week in a nasty and illiquid meltdown in that market.

The move was hastened by the shocking 0.1 percent drop in the core consumer price index, the first outright decline in seven years. Forecasts of first-quarter growth have tumbled after a spate of weak March data. Some economists have warned that the CPI was a fluky number, likely to be followed by a resumption of the upward trend toward the Fed’s target. That may be the case, and growth may rebound in the second quarter as it has in recent years, but if they don’t, the Fed’s plan to boost rates in June and September will further be thrown into serious doubt. As it is, the market has cut the odds of a rate hike in June to just about 35 percent.

The internal dynamics of the bond market have added additional fuel to the rally as yields broke through the bottom of a trading range that has been in place since November. The yield on the benchmark 10-year Treasury note fell from as high as 2.63 percent last month to as low as 2.16 percent yesterday. Before last week, a yield of around 2.30 percent was where rallies usually stalled. Then again, it is perhaps unsurprising that supply is failing to meet demand in a market where the Fed is hoarding $4.5 trillion of Treasuries and related bonds on its bloated balance sheet at the same time big foreign central banks are still in the midst of massive quantitative easing programs while holding mountains of Treasuries as well.

This meant that those market participants who use charts and momentum indicators to guide their trading piled into new long positions. The talk now is that this rally may not end until the yield falls to the 2 percent area –- not far from where they were right after the election. Also, Asian investors have returned as substantial buyers in recent days (as always, the miniscule yields available overseas keep global investors looking at the U.S. as the high-yielder). Another bond-friendly driver has been the slowdown in corporate debt issuance. Finally, some wobbles in risk-assets such as equities have led to some cross-market haven demand for Treasuries.

The bond bears are a dwindling crowd, and they won’t get any help from the Fed until we are much closer to the June FOMC meeting because any tough talk from policy makers this far ahead leaves them at risk of a severe communications mishap. And while a rally of this magnitude has forced huge waves of short-covering, the sense is that many have only partially conceded defeat, moving their bets on higher rates into the shorter-maturity Eurodollar futures, where they think the Fed will eventually prevail.

This rally hasn’t been as violent or panicky as many of the bond squeezes we have seen the past few years. If anything, the jawboning last month was a reminder that the Fed is willing to push back when it feels it is being ignored. In that sense, it’s as if what doesn’t kill bond traders only makes them stronger.

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