Bond Traders Exit Pivotal Week With No Signs of Fear
There were many reasons for the U.S. bond market to make a major move last week. Traders were inundated with key events and economic news, from multiple central bank meetings including the U.S. Federal Reserve to Washington politics, and from the Treasury Department’s funding plans to reports on jobs and manufacturing. Perhaps that was all too much for traders to feel like they could accurately handicap the risks, so as the dust settled the Treasury market was basically stuck at where it ended the previous week in one of the least volatile periods in recent years.
In the market for U.S. Treasuries, options premiums have fallen back to new lows and there is no sign of fear evident among complacent traders as they sit around and wait for the Fed’s December meeting and watch how the Republican tax plan unfolds in Washington. Once the business-friendly template was released, the lobbyists and dissenting legislators went after it like starving hyenas, especially the housing industry after it saw the deductibility of mortgage interest cut in half at the high end of that market. It seems that the only thing all parties agree on is that the bill could be delayed well into 2018, and it will not resemble the package offered last week. That leaves bond traders uncertain about the long-term supply-side impact from the tax cuts, and unwilling to bet this early on its success or failure.
For the fundamentally-driven investors, any positive economic impact from tax cuts is icing on the cake, as growth in the U.S. looks to be chugging along at a faster pace than in recent years. After Friday’s trade and factory data, the thinking is that the three percent increase in gross domestic product on an annualized basis could be replicated again in the fourth quarter. That would mark three successive quarters of expansion at three percent or more, after eight years of steady 2 percent growth. The bullish case on the economy was bolstered last week by steamy reports on consumer confidence at a 17-year high and a potent ISM services reading above the 60 mark. The jobs report, which is often a market driver, was a mixed bag due to the hurricanes, but a drop in the unemployment rate to 4.1 percent was eye-popping.
In short, the American economy is on a tear, with only one thing missing being any evidence of inflationary pressures. The super-tight labor market isn’t spurring widespread wage gains, with average hourly earnings in the jobs data up a measly 0.1 percent.
This Goldilocks-like environment of faster growth and sluggish inflation is keeping equity markets buoyant, but the bond market is struggling once again with a large bearish position that is limiting the impact of the good economic news. In other words, there are no surprises in the data that justify bond investors changing their outlooks. As a result, even though 10-year Treasury yields finally broke above 2.40 percent in late October, a level that some bond mavens such as Bill Gross and Jeff Gundlach have proclaimed would the beginning of a major bear market if breached, yields have trended back lower as a large number of traders with big short positions were forced to cover. The sight of U.K. gilt yields falling some 10 basis points after the Bank of England boosted interest rates was emblematic of this kind of oversold positional situation that exists in many major developed bond markets.
This week will likely be a quiet one for bond traders, as there is no big U.S. data of note or major central bank meetings. The focus instead will be on the Treasury Department’s refunding supply package of three-, 10- and 30-year bonds. While the debt managers in Washington haven’t increased the auction sizes as some analysts anticipated, they have emphasized that they will front-load the huge increases in issuance into maturities of five years or less. But then again, that is for 2018.
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