Relentless Bond Rally Has Traders Wondering What They Missed

For the past few months, Priya Misra viewed the bond rally as mainly driven by technical factors such as market positioning that would soon reverse.

Twice, the global head of rates strategy at TD Securities recommended her clients bet against the rally in Treasuries, expecting strong economic momentum and elevated inflation to push yields higher. Twice, she was forced to abandon the call as bonds kept gaining.

Now she’s wondering if falling yields point to cracks in the global economy and the possibility that the Federal Reserve is making a policy error by signaling plans to pare stimulus more quickly than investors and traders may deem appropriate.

“We can all see why technicals can move us away from fair value for some time,” Misra said. “But if it stays there for two months, that’s when you start thinking it must be something fundamental here, or big asset allocation here. It’s not just positioning because nobody is fading it. It’s a weird market.”

The bond rally that was initially dismissed by investors and analysts as having little fundamental support has proven persistent. Yields on 10-year Treasuries are on track to fall for four straight months, something they haven’t done since the onset of the pandemic. At around 1.3%, they’ve dropped from a more than one-year high of 1.77% at the end of March, in part amid the rise of dangerous Covid-19 variants.

What’s more, 10-year real yields, viewed as the market’s purest read on growth because they strip out inflation, are back below minus 1%, and around the lowest since February. The slide means that next week’s auction of 10-year Treasury Inflation-Protected Securities may draw a record low yield.

The latest dive in long-term borrowing costs happened even after reports this week showed surging inflation and stronger-than-forecast retail sales. The seeming disconnect has left some market participants scratching their heads.

“Bond traders used to worry about inflation,” said Ray Remy, co-head of fixed income at Daiwa Capital Markets America. “Somewhat alarming” inflation figures and “nonstop” Treasury supply are sustaining the widespread view that long-term yields are too low, he said.

But for him, the Fed’s bond buying, along with its forward guidance and the U.S. yield advantage versus Europe and Asia are the main forces at work behind lower yields.

Among other possible explanations, short-covering has gotten a lot of attention — essentially market players bailing on reflation wagers. The latest weekly JPMorgan Chase & Co. survey showed a net 23% of clients short Treasuries, down from 33% in mid-June, which was the largest short bias since 2017.

However, the fact that the market is still leaning bearish — meaning more short-covering potential — suggests the rally isn’t over, said Ben Jeffery, a strategist at BMO Capital Markets. He expects 10-year yields to fall toward about 1.21% in coming weeks.

Seasonality is also a consideration. Treasuries have tended to rally in July and August as corporate bond sales dwindle and Japanese investors swoop in, according to TD’s Misra. Over the past two decades, 10-year yields have declined by an average of 4 basis points in July and 16 basis points in August.

But bigger picture, investors and analysts are concerned if bond markets are signaling a significant growth slowdown is ahead amid resurgent Covid-19 infections, just as rising inflation prompts central banks to reduce support.

While Fed Chairman Jerome Powell told Congress this week that tapering bond purchases is still a “ways off,” one of his colleagues said it’s time.

In a report this week titled “What does the Treasury market know that we don’t?,” JPMorgan strategists said yields imply an economic growth rate of just 0.5% over the next year, nearly 3 percentage points below their forecast.

The bond-market narrative of a policy mistake or growth slowdown, though, doesn’t jibe with signals from other assets, with stocks near all-time highs and corporate bond spreads at historical lows.

Misra said she’s still looking for 10-year yields to move toward 2% by year-end, although she has no plan to bet against Treasuries right away.

“I am just not putting it on until I see a catalyst,” she said. “I don’t know what the next catalyst will be.”

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