Markets: Fixed Income
On Wednesday, global bonds shot higher late in the session on the FOMC (Fed) decision to expand its balance sheet by expanding the existing programs of purchasing Agency and Agency MBS debt and by announcing the start of a program to purchase $300B of longer-term Treasury securities.
The US Treasury curve shifted sharply lower with the belly of the curve greatly outperforming the wings. Indeed, 2-year yields fell 22 and 10-year yields 29 basis points. The 5- and 10-year yield dropped respectively 40.6 and 47.3 basis points. The German cash market was closed when the decision was announced, but the Bund future surged to 124.45 from 122.30 before the decision, suggesting that the cash market will open sharply higher this morning.
The eco dataflow was thin. The US CPI (like the PPI on Tuesday) suggested that deflation fears are a bit overdone or at least a bit premature. Indeed, core and headline CPI were above expectations and suggested that the disinflation process is happening slower than previous reports had suggested.
Treasuries through the roof on Fed decision to purchase Treasury securities
Today, the calendar is well-filled with the weekly claims, leading indicators (February) and Philadelphia Fed (March). Last week, initial claims came out slightly higher than expected, while the continuing claims rose by almost 200 000. For this week, the consensus is looking for a slight increase in both initial and continuing claims. Last month, the Philadelphia Fed showed a sharp deterioration in business sentiment as the headline index plunged to -41.30 (from -24.30) after improving in the two previous months. For this month, the Philly Fed is expected to show a slight increase (-39.0 from -41.3), but we see the risks on the downside of expectations after the disappointing NY Fed earlier this month. Leading indicators for the month of February are forecasted to show a drop by 0.6% after rising in December and January, but a weaker outcome is not excluded.
The market will chew further on the surprise decision of the Fed to expand its program of asset purchases, especially of Agency and Agency MBS debt. However, it was the decision to start purchasing $300B of longer-dated Treasuries that stunned friend and foe. The details of this program are of paramount importance for traders. The purchases will be concentrated in the 2-to-10-year sector of the nominal Treasury curve, although purchases will occur across the nominal Treasury and TIPS curves. They will be conducted with the primary dealers via competitive auctions and will take place two to three times a week, starting next week. Further details will be made available next week
Technically, the 10-year yield fell below 2.60%, neckline previous double bottom. If confirmed that would again make the technical picture outright bullish. The 5-year yield (now 1.54%) made a technical important move too, dropping below a previous low (1.62%) and breaking below a bull flag (see graph below). This theoretically opens the way eventually for a retest of the cycle lows at around 1.20%. The 30-year yield on the contrary tested a similar important technical level at 3.40%, but failed, also when it became clear that the bulk of Fed purchases will take place in the 2-to- 10-year sectors of the curve. The 2-year yield remains in a sideways range between 0.60 and 1.10%.
Regarding trading, there might be still some more repositioning in favour of Treasuries in the days ahead, but if the price action of Gilts following the BOE decision on QE is a good precursor, some profit taking may follow afterwards.
The big question is whether long term investors should be so happy with the Fed printing ever more money. This increases risk on inflation or/and a big reversal higher in yields if the Fed policy gets traction in the real economy and the QE policy is unwind. The move of course also poses dangers for the currency, the dollar. The Treasury market is very dependant on foreign buyers, especially China and any confidence crisis in the dollar might lead to a strike of the foreign buyers of Treasuries. The Chinese leadership already last week questioned the credibility of the US policy. Has the US warned the Chinese of recent decisions? If not, what will the Chinese do? Buying at current “abnormal” low levels is not very enticing. Selling some Treasuries …to the Fed… might leave them with capital gains and allow them to reduce exposure, but the huge amount of their portfolio means that only a small part of it can be sold. It is still early days to have a good view on all the implications of the Fed’s recent decisions, but some suspicion is warranted. Policy in unchartered territory policy moves might cause problems, sometimes in corners one wouldn’t expect them to pop up.
While these longer term considerations are important, from a short term trading perspective, it is unwise to fight the Fed. Given also the bullish technical pictures for the belly of the curve, one should consider it as a buy on dips (in price) environment. So an increase in 5- and 10-year yields towards 1.60 and 2.60% might be considered as buying opportunities (in short term perspective).
