Markets are like pendulums. They go too far in one direction and then go too far in the other.
They say ‘Never say Never’ in markets, more so when the consensus call is for a certain trade. Betting against the price of US government bonds was a winning play earlier this year with hedge funds, raking in sizable gains as the economic recovery gathered pace.
The investor consensus that took several months to build, that is, strong economic growth and high inflation would lead to significantly higher interest rates, is beginning to disintegrate, causing considerable pain for those caught in this trade.
The reflation trade was crowded and people jumping on the bus late had to pay a price for the skewed positioning.
Now, the word on the street is – ‘peak growth, peak inflation and peak stimulus’ may well be behind us.
Ironically, it all started with the Fed moving the ‘dot plot’ higher, signalling that they may raise rates sooner than expected.
Isn’t that a bit ‘perplexing’ or ‘counterintuitive’? How can long term yields crash if the Fed is actually raising rates sooner?
The answer lies in the fact that the Fed is prepared to act ahead of schedule to rein in inflation before it goes out of whack. In any case, Growth and Inflation may well be peaking as we move into the second half of the year.
So, where does lower structural inflation and lower growth expectations take us? You guessed it, lower interest rates in the long term.
Having said that, the bulk of the downward trend in the US 10 year yields has been because of technical factors rather than genuine fear of growth crashing.
Let’s take a look at some of the technical spoilsports in the journey of uptrending US yields
1. Positioning
Heavyweight fund managers, including large hedge funds, have been holding bearish positions on US treasuries for months. The skewed positioning did contribute to the sharp move lower in yields, courtesy of short-covering. However, despite having to endure short-term pain, large fund managers continue to believe that the strength in the economy is for real and rates are headed higher sooner than later.
2. Reduced Supply and more demand
Forget Tapering for the time being, the last two months have seen unprecedented buying by the Fed. The Fed balance sheet has increased by $337 billion just in the last two months, the largest in more than a year. This demand has come alongside a reduced net supply of Treasuries in June as a larger quantity of outstanding debt reached maturity, compared with previous months.
3. Rebalancing from Institutional Players
Quarter-end rebalancing from large institutional players saw huge demand for fixed income. Given the huge rally in equities, rebalancing flows were significant to trigger a rally in US treasuries and aid the yield collapse.
There have been some concerns on the growth front recently with the US Composite PMI cooling to a 4-month low in July, in addition to the renewed concerns with respect to Covid as the Delta variant spread in US and Southeast Asia. Despite this, we continue to believe that while growth may not surprise to the upside hugely from here-on, the inherent strength of the economy is here to stay.
Long story short, despite US 10 year yields crashing to 1.13% on 19th July, we are still keen to stick our neck out and call for US yields to be closer to 1.75% than 1.25% come 31st Dec 2021
