by Guy Haselmann, Managing Director, Product Solutions, OpenDoor Trading LLC
As I resume my market commentary, my intention is to provide content that is similar to my prior work. Before I begin however, I thought it prudent to make a statement about my recent transition to OpenDoor Trading (ODT). Simply stated, Scotiabank is a world class firm with many truly outstanding people. However, ODT presented me with an exciting opportunity to join a firm with a brilliant and timely product that provides a solution to liquidity problems in off-the-run Treasuries and TIPS.
· The basic arguments behind my aggressive bullish stance on US Treasuries (USTs) over the past few years overlaps nicely with the guiding principles that has driven ODT to emerge with such promise. The Treasury trading ecosystem has materially mutated due to factors such as regulation, globalization, demographics, and geo-politics.
· In such, USTs in recent years have been driven more by technical factors than by fundamental factors. Too many have missed this fact. On several occasions, I have gone into detail on many of those factors, but a brief summary of them can be found in my January 4th note, “The Bond Awakens” (here). Add the fact that Global central bank QE programs are designed to unhinge asset prices from their fundamental value and it is not hard to see why the technicals dominate.
· The changing landscape has fueled a bifurcated market between on-the run (OTR) and off-the runs (OFTR) Treasuries. The six OTR issues represent less than 2% of all issues, yet account for 68% of daily volume. Susan Estes, the CEO of ODT, has written about this dynamic in a two-part series (here and here). This bifurcation is damaging price discovery in the Treasury market and negatively impacting trading decisions.
· One of the main reasons for this is the fact that the Treasury market has more than doubled since 2007 at the same time that there are fewer primary dealers and a regulatory-induced weaker ability to warehouse securities.
· Many have also begun to warn about Treasury market dangers due to market valuations. These warnings rarely include well-thought out reasons, but are based mainly on the sticker shock of exceptionally low yields. They also include fears of inflations, but maybe CB’s can only produce asset price inflation and hyperinflation (e.g., Venezuela), and not a targeted amount of inflation (i.e., near 2%).
· I concur that the $10 trillion+ of global sovereign and corporate bonds trading at negative yields are an unsustainable paradigm. Yet, the longer foreign central banks are able to maintain such low yields, the more capital that will likely flow into positive yielding US Treasuries. When a sell-off in negative yielding bonds does occur, USTs will be dragged lower, but should outperform due to the technicals I referenced. Either way, spreads will narrow from outperforming USTs (e.g.; Bund-US spread sub 100, Spain-US spread from -6 to +100+) .
· The market has priced-out the Fed for tomorrow’s FOMC meeting. Yet, if the Fed were truly ‘data dependent’ it would hike rates, since their duel mandates have been achieved. The unemployment rate is 4.7%, and core CPI above 2%. Wage pressures and consumer spending are rising, and unemployment claims are low and steady. Many have argued that UST’s will sell off if the Fed tightens this week, or if the UK votes next week to remain in the EU. I disagree. If the Fed hikes rates, the yield curve will flatten and more buyers will storm into the back end. In addition, the UK vote seems to have a positive asymmetric risk profile benefiting USTs.