Unloved Treasuries
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.
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· 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.
· I have never understood why the UK ‘remain camp’ tactics were based on fear. If the merits and benefits of remaining in the EU were so compelling, then shouldn’t those benefits have been emphasized instead? After all, the UK has had a proud history for many centuries; therefore, I bet few people have much fear of going it alone. In the end, the UK will figure it all out and adjust accordingly should they vote to leave.
· Political fear might really be about trying to prevent a precedence for an exit from the EU. In a sense, the EU has already experienced ‘quasi-exits’ with the election of anti-EU parties in Poland and Hungary, and the gaining popularity of fringe parties in many other countries.
· The electorate are clearly unhappy in the EU (and US). The lack of EU coordination on such issues as refugees, banking deposit insurance, or various fiscal measures, shows more disunity than unity. Therefore, it is hard for the UK voter to know what ‘union’ they are actually voting to be a part of.
· In summary, I caution disliking Treasuries due to low yields without understanding the driving technical factors. Rather than expecting a steep and quick rise in UST yields the way many are vocally calling for, I believe the opposite is more likely.
· Those who are skeptical about a sharp drop in yield from these levels should look at this year’s chart of the Japanese 30-year bond. It was yielding 1.20% at the end of January and fell around 80 basis points within 2 months. It now yields 0.22%. The Fed is no longer doing QE like the BoJ, but as mentioned there are various compelling factors driving yields lower. I still expect long-dated Treasuries to hit all-time low yields sooner than expected.
“Talk about your plenty, talk about your ills, one man gathers, what another man spills.”
–Grateful Dead
Cheers, Guy
P.S. Please let me know if you would like to be removed from my distribution list or if you have colleagues who would like to be added. Thank you.
Guy Haselmann
Managing Director, Product Solutions
OpenDoor Trading
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