Notes from the Desk: A Perfect Storm in the Bond Market
May 30, 2018 By Sage Advisory
A perfect storm in the bond market just occurred as Hurricane Fed crossed paths with an Italian tropical storm and U.S. Dollar high pressure system. After hitting a high of 3.12% on 05/21/18, 10-year Treasury yields have fallen 25bps, touching a low of 2.76% yesterday. What’s driving this move? It’s a confluence of curve slope, U.S. Dollar strength, and Italian political strife. With this mix of factors, the Fed may find a neutral policy rate sooner than expected. Any reprieve from rate hikes would deliver much-needed rate stability and offer bond investors some upside for the balance of 2018.
The slope of the Treasury yield curve, or the difference between short and long rates, has been on the decline since the Fed began its current rate hike cycle. With the difference between 2-year and 10-year Treasuries at 45bps, the Fed is in danger of inverting the yield curve with three more hikes this year. In the past, inverted yield curves have preceded economic slowdowns. Rate hikes concurrent with balance sheet reduction could mean the Fed’s total policy mix moves past normalized and right into restrictive territory. Numerous Fed presidents, including Kaplan, Bostic, and Bullard have offered hesitation over inverting the yield curve. Without a pickup in long-term yields, September and December rate hikes become questionable.
Another factor at play recently is the U.S. Dollar, which has rallied 6% since April. Strength in the U.S. Dollar creates headwinds for improved inflation. Dollar strength has also caused some consternation for international equity investors, with emerging markets (EM) down 5.9% since the dollar began its rally in April. Policy hikes supporting additional dollar strength puts the Fed at risk of amplifying downward pressure on U.S. inflation, raising the local currency cost of U.S. Dollar-denominated EM debt, and increasing concerns of a policy overshoot.
Italian political infighting and discord has caused a move higher in Italian bond yields and risks another Eurozone crisis. In case you weren’t looking, Italian 2-year government bonds rose 1.83% yesterday to close at 2.70%, setting up another battle between Germany and the Eurozone’s southern region. While this one will likely be resolved as others have, with the Eurozone surviving, the pain to arrive at an agreement will be unpleasant and unsupportive of European economic growth. This matters because the ECB will have little appetite for QE tapering if Italy becomes a problem.
Ultimately, the upward ascent of U.S. bonds yields is running into resistance.
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