U.S. Treasuries: The Reversal Came And China Is To Blame

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Summary

The first phase of the expected big correction in US Bonds has occurred.

China is the main driver behind the plummeting of US Treasuries - a move which is expected to continue.

The most important long-term resistance of 10-Year Treasury yields is around 2.2%.

As discussed in the last couple of months, a big reversal of the bull market in US Treasuries (NYSEARCA:TLT) was going to be the next big move, and investors were warned to brace themselves for unusual volatility. Currently, the first phase of this US bond correction has occurred, with much more room for bond prices to drop. The culprit for this dynamic is certainly the revival of the Chinese economy and the inflationary effect it can cause on bond prices. Investors are used to looking at China as struggling economy which requires enormous rebalancing efforts, trapped in a long soft-landing phase. As a result, they were surprised by the recent stream of positive Chinese releases, which were highly unexpected. The new Chinese rebounding trend has the capacity to extend itself and spread some of its positive effects to the rest of the world. All these circumstances make the US bond market look increasingly vulnerable, and pave the way for additional yield hikes, especially in the long end of the curve, until yields approach their long-term resistance.

TLT

Source: tradingview.com

The China Factor

The long end of the US yield curve is anchored to domestic macroeconomic dynamics as well as to international ones. Given that the domestic economy is lack-lustering, confined inside a huge liquidity trap, all eyes have turned to China, and for good reason. China is the only reliable growth engine in the world, which could jump-start the global business cycle. All latest releases point to that direction, with manufacturing and services PMIs exhibiting resilience. On the consumer front, the Consumer-price index for September rose by 1.9% YoY, much higher than consensus, signaling that the domestic economy is picking up.

On the manufacturing front, the latest Producer-price index surpassed expectations and recorded the first positive reading since 2012, by increasing 0.1% YoY. The reversal of the factory deflation is clear proof that this year's commodities rally began impacting the real economy. The recent commodities boom has greatly affected the trade balance as well, with the latest figures for September exhibiting a much lower surplus than expected. The Baltic Dry Index, a global index that tracks the shipping costs of basic raw materials, is headed for a new high this year, confirming not only that the demand for commodities is substantiated, but that it has the potential to grow, mainly due to healthy Asian demand.

BDI

Source: stockcharts.com

All these developments are clearly bearish for US bonds, as they affect both inflation expectations and international capital flows. The Chinese inflationary indications at the manufacturing as well as at the retail level of the economy, if sustained, will gradually impact the long-term US inflationary expectations. In fact, 10-Year breakeven inflation rate, which is the level of inflation that the Treasuries market expects to witness over the next ten years, has been steadily rising for quite some time. The rise in such long-term inflation expectations, irrespective of its source, is a detrimental factor for long-term US bonds. Long-term bond yields need to rise commensurately in order to compensate investors for losing their future purchasing power due to expected inflation.

The reduced Chinese trade surpluses can also greatly weigh on the US Treasuries market through two avenues. Firstly, they leave less money available to be invested in US government notes, and secondly they reduce China's inflows so that the PBoC has to burn more of its reserves to defend the yuan peg to the US dollar. Burning more reserves means that SAFE needs to dump US treasuries in order to finance its FX interventions.

This being said, the rejuvenation of the Chinese economy can seriously threat the US bond market through higher inflation and lower US inflows. Actually, markets have already begun to witness such an adverse effect, as the long-term bond yields have increased much faster than the short-term ones. China's macro trends suggest that these negative reverberations on US bonds will continue in the foreseeable future. The technical prospect of the US bond market verifies the underlying macro picture, indicating that the Chinese factor will prove to be much stronger than anticipated at the moment.

Technical Dynamics of the US Bonds

The 10-Year Treasury yield surpassed the September high and is approaching 1.80% amidst a renewed sell-off wave. Despite the magnitude of this bearish move in bonds, the market seems to be heading towards the 1.90%-2.00% area, where the major resistance of the downtrend line resides (trend line A). If yields break this trend line to the upside, there is a possibility that they might reach the 2.20% level (trend line B). In order for the 2.20% level to be penetrated, serious macro developments need to take place, beyond anything that is foreseeable at the moment; one of them being the US economy exhibiting reflationary capabilities.

TNX

Source: tradingview.com

This projected move of the 10-Year yields will most certainly be accompanied by a smaller increase in 2-Year yields, allowing the yield curve to steepen even further. The short-term bond yields will be more hesitant to move to the upside, as interruptions between every successive rate hike are expected to be quite long.

The big correction in US bonds has started. It will be a bumpy road with more selling waves along the way. China is, and will, probably stay the single most important driver of this market move, as the US economy falls behind. Will the US eventually manage to take the lead? The Consensus is negative; but who was expecting China to revive in the first place?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The views expressed in this article are solely those of the author, provided solely for informative purposes and in no case constitute investment advice.