The Crazy Bond Market - Part III

by: John M. Mason

The US bond market appears to be catching all the financial cross-currents going on in the world today and need to be watched closely.

Over the past three months, longer-term interest rates have responded to the Trump tax bill, the rising value of the dollar, which impacted emerging markets, and the Italian political crisis.

The yield on the 10-year Treasury is expected to rise further, but the trip there might be very interesting given the international flow of money seeking a "safe haven."

Well, the yield on the 10-year US Treasury note has rebounded to 2.97 percent this Wednesday and could go higher. What a ride the market has taken over the last several weeks. On May 17, the yield on the 10-year closed above 3.11 percent.

Then, the fall came: the security closed to yield around 2.78 percent on May 29, just after the attempt to form a government failed in Italy. Since then, as events in Europe seemed to quiet, the 10-year yield began to move upwards again.

My prediction to watch the bond market in 2018 made in December 2017 has been spot on. It seems, almost, as if every major thing going on in the world has been captured in the US bond market during the year.

First, in early January, the bond market began to reflect the passage of the tax reform bill in December. The real rate of interest, in this case the yield on the 10-year US Treasury Inflation Protected securities (TIPs), closed the year at 0.47 percent.

By the twentieth of March, the yield on the 10-year TIPs had risen to close to 0.80 percent. All during this time, the inflationary expectations built into the nominal bond yield remained relatively stable. In early January, inflationary expectations were around 2.00 percent, while they were only about 2.05 percent in the last third of March.

It seems as if market participants saw the tax reform bill adding to economic growth more than it added to inflationary pressures. At least, this is what the market results lead us to believe.

Then things started to get crazy. I won’t take a lot of time talking about some of the things that went on in late March and April, because I have done that elsewhere. See, for example, my March 30 discussion of the crazy bond market.

I followed this up on April 24 with a second look at the crazy bond market.

Then things got even crazier as the value of the US dollar rose in world markets. The US economy seemed to be growing faster, inflation seemed to be picking up, and officials at the Federal Reserve System reconfirmed that they intended to keep on raising interest.

The impact of all this information fell upon emerging markets in early April, on emerging market currencies and on emerging market financial markets. The brunt of the changes fell particularly hard on Argentina and Turkey.

And, then on May 29, we had the governmental situation in Italy…and Spain…and Greece…captured the headlines.

This drew another post.

The interesting thing is that with the strong dollar, I wrote on May 21 about how the stronger dollar seemed to reflect the fact that the US economy was growing stronger.

The consequent effect of this effect was the rise in the real rate of interest. The yield on the 10-year TIPs went from around 0.80 percent on March 20, to 0.93 on May 17.

It should be noted that during this time period, given the run against emerging market currencies, the emerging nations experienced the heaviest outflows of money in 18 months, another time when the value of the US dollar was rising in foreign exchange markets.

Since May 17, however, the yield on the 10-year TIPs dropped from 0.93 percent to 0.80 percent.

It seems as if money was now leaving Europe and the emerging markets money was finding a way to the United States. I have written several times over the past year about how “risk averse” monies have left the United States since the election of Donald Trump as president, and how this movement of funds contributed to the rise in the yield on the TIPs in early 2017.

Well, now money seems to be moving back into the US because of nervousness about other places in the world.

And, this nervousness is being picked up by analysts.

For example, in Bloomberg we read, “World Bear Market Would Likely Begin in Euro Zone.”

Then, well-known economist Kenneth Rogoff writes a piece for Product Syndicate, “Are Emerging Markets the Canary in the Financial Coal Mine?”

Seems as if people are looking for signs of when the next Lehman Brothers failure is going to take place that will result in a financial market collapse.

Lots of things are going on in the world and it seems as if a lot of them are having an impact upon the US bond market and longer-term US Treasury yields.

But, one cannot ignore the role of the Federal Reserve System in this scenario. Federal Reserve officials have kept a steady hand on the wheel during all this. And these officials are still affirming that they will raise their policy rate of interest at least two more times this year…if not three times. And, they are planning to continue rate increases into 2019.

Furthermore, the Fed continues to reduce the size of its securities portfolio and shows no sign of easing up on this move.

Where will the yield on the 10-year US Treasury note go? I am on record of thinking that it will go up into the 3.50 percent range over the next year or so. The argument for this is that I believe that the yield on the 10-year TIPs will rise to about 1.40 percent and inflationary expectations will stay around 2.10 percent. Adding the two together, you get a nominal yield of 3.50 percent.

Another argument comes from George Magnus of Oxford University, writing in the Financial Times. Mr. Magnus writes that John Williams, president of the Federal Reserve Bank of New York, believes that the real rate of interest should be around 0.50 percent, while the “median view of policymakers is 0.80 percent.” This would mean that with inflationary expectations around 2.00 percent, the nominal yield on the 10-year Treasury note should be in the 2.50 percent to 3.00 percent range.

Mr. Magnus refers to his view as “the complacent view” and is connected with slower economic growth. He concludes, “For now, only the complacent think 3 percent yields mark the top.”

The bond market is giving us a lot to think about these days. We should continue to keep watching what happens here.

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.