Bond Market Pressures Build as Summer Drags On
There are times in markets when the forces of change seem to move as slowly as the tectonic plates that make up the Earth’s crust. This is one of those times for the U.S. bond market -- but don’t take that to mean there aren’t some acute pressures building beneath the surface.
After a sharp rise in the second half of 2016, volatility in the rates market has fallen to historic lows this summer, and yields on 10-year Treasuries are stuck in the middle of an already tight range of about 2.15 percent to 2.40 percent as both bulls and bears move to the sidelines and wait for the next set of data that establishes a trend. The bond bulls point to four straight weak core Consumer Price Index reports, which have dashed any concern that inflation will soon accelerate. The bears point to a strong labor market, albeit one with little wage growth, and a pending increase in the supply of longer-term debt securities to finance a growing U.S. budget deficit. Their case has been strengthened by signs of a recent inflationary impulse in many commodities markets, especially in the metals sectors dominated by Chinese demand.
Whatever their differences, both camps agree on one thing: The Federal Reserve is fixated on its late September policy meeting, which is when the central bank is expected to start reducing its massive $4.5 trillion pile of Treasuries and mortgage-backed securities. The Fed’s signaling on this historic removal of accommodation has been so consistent and transparent that it would take a major market shock to derail the process.
The market reaction has been minimal, especially compared with the collapse in bonds during the so-called “taper tantrum” of 2013, when the Fed’s then-chairman Ben Bernanke hinted that the central bank could soon start slowing the purchase of bonds. One reason markets are sanguine about the pending disappearance of the Fed as a huge supporting buyer is the slow start to the program in late 2017. Another is the willingness of foreign investors, particularly in Asia, to pick up the slack when domestic bond owners are selling.
But the slow start will soon give way to a faster pace once the program gets going in earnest in 2018, when the Fed’s retreat leaves an extra $200 billion or more of Treasuries for others to absorb annually. The funding gap will become even more daunting when one figures in the likelihood of a significant deterioration in the budget deficit over the rest of this decade. A recent survey of primary dealers by the Treasury Department found that Wall Street expects the government’s borrowing will increase from $525 billion in calendar year 2017 to $1.01 trillion in calendar year 2020.
Political analysts are pessimistic about the prospects for a significant fiscal bump to the economy anytime soon after the failure to repeal Obamacare, and the Treasury market has discounted any such event so thoroughly that even limited success on a smaller-scale tax bill could boost growth estimates enough to trigger a bond rout. Then there’s the European Central Bank, which is talking about the need to slow its bond purchase program.
All that is farther out the timeline. There’s a more immediate event that has the potential to shake the market out of its doldrums, given that the hawks at the Fed are showing no signs of retreating from their insistence that a vibrant American labor market will eventually feed into higher wages and faster inflation. On Friday, the Labor Department will release its Consumer Price Index data for July. The median estimate of economists surveyed by Bloomberg is for the gauge -- excluding food and energy costs -- to rise 0.2 percent, up from 0.1 percent in June. That would put the measure back in line with its recent trend, and could be enough to keep the Fed on track to raise interest rates a third time in 2017.
It won’t be long before the tectonic plates of bond supply, economic growth, inflation and investable cash grind so hard that something breaks. That could begin to happen as soon as this week.
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