For Bond Traders, 2018 Won't Be Business as Usual
Around this time of year, most financial columns endeavor to divine what’s ahead. And most tend to have some form of the same disclaimer made famous by New York Yankees Hall of Famer Yogi Berra: “It’s tough to make predictions, especially about the future.” With that in mind, here’s an attempt to provide a sense of what to expect in the U.S. bond market for 2018.
To understand where the market may be headed, it’s important to take a quick look back at 2017, which was one of the dullest years in the history of fixed income. Benchmark 10-year U.S. Treasury yields ended less than 5 basis points from where they started 2017, marking the least amount of volatility in 40 years -- due largely to benign inflation. Shorter-term maturities were a different story, as two-year yields moved steadily higher from less than 1.20 percent to above 1.90 percent. The bear market in this part of the curve was a reflection of the Federal Reserve’s resolve to raise interest rates and start shrinking its balance sheet along with a strengthening economy.
Most pundits usually just forecast a continuation of the trends that worked well in the prior year. This has been especially fruitful for Treasury market bulls, as the bonds have generated positive returns almost every year since then Fed Chairman Paul Volcker raised the federal funds rate to 20 percent in the early 1980s to get inflation under control. More than a few hedge funds stumbled mightily in recent years by repeatedly positioning for a "Big Rate Reversal." As such, most calls are for more flattening in the yield curve in 2018 as short-term yields rise 50 basis points to 75 basis points and long-term yields hold steady. In fact, an inverted yield curve seems to be the consensus bet, and positioning remains heavily biased toward that happening.
But in terms of 2018, a more useful Yogi aphorism might be “If you don’t know where you’re going, you might not get there.” Coming into 2018, traders are no longer ignoring the central bank’s stated path toward rates with the same insouciance as prior years. Traders are pricing in 2.75 of rate hikes over the next two years, and although that’s well short of the Fed’s projections, it’s a healthy sign of newfound respect for the central bank amid a strong economy and a drum-tight labor market that should give wages a long-delayed lift.
While we wait for that, the speed at which the Fed shrinks its balance sheet will accelerate, and the Treasury Department will raise about 60 percent more new money this year, in part, to pay for tax cuts. Although the Treasury’s plan to issue the bulk of this debt in the front end of the curve added upward pressure on short-term yields in 2017 while helping to keep longer-term yields in check, I posit that the long end of the yield curve will not be as nonchalant about the supply picture as last year.
Even small bumps in the supply of longer-term debt could have an outsized impact at a time when dealers are pulling back. Last week’s auctions of two-, five- and seven-year notes were ugly even though the overall market was rallying on year-end short-covering and sector rotation demands. When the Treasury boosts five-year auction sizes to $50 billion a month from the current $34 billion, there could be a knock-on effect in other parts of the bond market, raising rates on everything from foreign government debt to corporate credit.
Will a two-year Treasury yielding from 2.25 percent to 2.5 percent, or a five-year note yielding from 2.50 percent to 2.75 percent attract cash that’s sitting in 10-year notes yielding about 2.40 percent. I would bet they do. Traders got a taste of what’s likely to come on the first trading day of 2018, as the long end of the yield curve was getting pummeled, with 30-year yields rising by some 7 basis points.
What the market is likely to experience is a sort of parallel shift to higher yields as the labor market tightens further, supply increases and the temporary factors that helped suppress inflation last year are not repeated. That would keep the Fed on its slow and steady rate hike path while containing volatility at historically low levels.
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