The Bond Market's Latest Rally Is No Knee-Jerk Reaction

Unlike many prior squeezes in U.S. Treasuries, there are no signs of wretched excess.

The bond bulls are in charge.

Photographer: Michael Nagle

Many pundits are describing the latest move in the bond markets as little more than a knee-jerk reaction to rising geopolitical tensions amid a broader risk-off environment. They'd be wrong.

Unlike many previous squeezes in U.S. Treasuries, this latest move -- which has pushed yields on 10-year notes to the lowest of the year -- is important because it came without the usual signs of wretched excess in the form of speculative over-positioning. Although this rally has had its share of momentum players seeking to ride the wave, those types have been bullish for months and did little to exacerbate the move.

This time, the message from the bond market to the Fed is emphatic: There is a minimal need for further interest-rate increases once policy makers begin shrinking the central bank's $4.5 trillion balance sheet this month. The U.S. political and global security environments, along with little to no inflationary pressures, have altered the rate hike narrative, despite the very healthy 3 percent growth rate in gross domestic product for the second quarter and decent jobs growth.

The market appears to be establishing a lower yield range for the foreseeable future, with the bulls taking aim at the pre-U.S. election levels of well under 2 percent on 10-year notes. While over a longer term the effects of hurricane damage can be stimulative, they will depress the data over the short term, muddying the economic outlook and making aggressive Fed moves less likely. 

The Fed won't fight this until November at the earliest, if at all. Policy makers haven't protested too loudly about the bond market’s stubborn refusal to respond to rate increases and the risk of more to come. After all, policy makers are focused on the likely announcement in two weeks of the balance sheet tapering program, which will happen under almost any circumstance barring a major war or stock-market crash.

Bond traders are betting that softening up the market for a possible third 2017 rate hike increase in December isn't urgent business for this Fed right now. That opens the door to more inflows into Treasuries from haven-seeking investors. The market odds of a December rate hike have dropped to around 25 percent.

The latest Commodity Futures Trading Commission data released Friday showed the smallest speculative short position in five-year Treasury futures since June 2016. That's a sign the perpetually bearish hedge funds are standing down, leaving the field to the buyers, and they are chasing yields to new lows.

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