For the past two days (and weeks, and months) the investing world was obsessed with just one thing: will the 10-Year yield break 3.00%, and what will happen to both Treasurys and stocks, immediately after. It did so today, briefly touching 3.001%, before retracing most of the move, only to close just below 3.00%.
Meanwhile, stocks tumbled, even if the slide was due to an largely unrelated combination of weakness in the new (Google) and old (Caterpillar) economy.
Still, as BMO’s Ian Lyngen and Aaron Kohli write, “achieving 3.0% 10-year yields is a big deal, until it isn’t.” Here’s why the response from the two fixed income strategists was nothing more than a yawn to today’s events.
Today we saw 10s reach 3.001% intraday, for the sector’s highest yield since January 2014… yawn. We’re not disinterested per se, but the long-awaited three-handle was summarily rejected as equities sharply declined.
What happened next is more interesting, and as the duo writes, “when a milestone such as this is reached, we often field a variety of inquiries and today we received two questions that were rather spot-on.“
Here are the two questions:
“First, is this a breach or a rejection?”
While our opening few lines show where we come down on the matter, it warrants an explanation of our interpretation of the difference. If the run-up in yields was accompanied by 10s closing above 3.0%, that would have been a breach or a breakout by any classic technical definition. Although in such a case a weekly close would be far more compelling than simply a daily one. In fact, a couple days above 3.0% that were subsequently reversed would be almost as constructive as the rejection seen today. Nonetheless, with risk assets once again in negative territory year-to-date, we struggle with any narrative that suggests the next move is a clear shot to 3.25%.
“The second question which we found notable was ‘why do 3.0% 10-year yields matter anyway?” First, here is the answer in the context of the broader, “consumption” economy.
Admittedly, there is a lot of wood-to-chop here, as they say. To be fair, there is little difference between 2.99% and 3.01% – just 2 bp in fact. However the signal the market is taking from the selloff is key, as is the implied path for future rates which becomes more uncertain when a range is broken. A bearish breakout intuitively implies higher yields, although as we can see in the response of risk assets, there is also the negative impact on the real economy to consider. The consumer will be (and has been) facing elevated borrowing costs as well in the form of mortgage rates, consumer loans, etc. – which eats into wallet-share; a particularly troubling development for an economy that is ~70% consumption.
Just as importantly, there are the equity investment considerations:
From an investment perspective, there comes a point at which even grizzled sellside market participants start to ponder adding 1-year bills yielding 2.20% to their portfolios, but we digress. More important than comparing the current yield of Treasuries versus investable alternatives, the implications of a higher baseline risk free rate increase the discount-factors for evaluating a variety of investments (beyond just equities) – undermining asset values throughout the real economy. That said, recasting expectations lower won’t occur immediately and the choppy price action in equities offers evidence of this reality.
Finally, here is what the BMO rates duo believe happens next from a “tactical bias” standpoint.
We’re eager to gauge the degree of market intelligence gained from the reconnaissance into the realm of 3.0% 10-year yields – both in the form of overseas follow-through and flows in the wake of this week’s auctions. On the plus side, we’re encouraged by the relatively strong rejection of 3.0%, but will be the first to note that it isn’t conclusive by any means. There are two likely outcomes at this point; first is that ~3% functions as a double-top and the week ends with 10-year yields safely below 2.90%. The second is that there is another period of consolidation immediately under 3.0% as the market makes basecamp (establishes a volumes bulge) ahead of another attempt to summit 3.05%. We’re leaning toward the former, but will be quick to concede that the latter is certainly a real possibility, and one which many have been playing for all year.
The significant short-base evidenced in the CFTC data persists and while this recent move has offered satisfaction to those in the bearish camp, it simultaneously represents something of a ‘make or break’ moment in the campaign toward sustainably higher rates. We’re sympathetic to the risk of supply indigestion, the modest tail at Tuesday’s 2-year wasn’t a good start to this week’s trio of auctions. That said, 2s are expected to see the largest increase in coupon auction sizes during the upcoming quarters and the 0.4 bp tail compares reasonably well with the average seen during the last eight Aprils of 0.2 bp. In addition, the 2-year sector subsequently rallied following the results, indicating a bit of relief given the details of the takedown.
We are retaining our medium-term bullishness and favor a retracement off the recent yield peaks. Momentum is oversold and while there is a strong positional skew favoring a further selloff – that can be a double-edged sword. In the event of a failure of the market to achieve higher yields, we’d look for a round of profit-taking that presses yields lower and triggers a round of capitulation. The range-trading theme remains very much our base-case call for this year – admittedly one that feels the least comfortable when yields are up against the top of the range.
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