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Bond Market Carves Path Back to Familiar Territory

The Fed's efforts to boost longer-term yields will be like pushing on a string.

By Scott Dorf

(Bloomberg Prophets) --It has been an eventful September in the U.S. bond market, with volatility finally making an appearance. Just don’t get used to it. Familiar trends are likely to reassert themselves sooner rather than later, which is to say that despite the Federal Reserve signaling its intent to raise interest rates a third time this year in December, its efforts to boost longer-term bond yields will be like pushing on a string.

The month started out with a panicky flight to quality that peaked on Sept. 8 as rising tensions with North Korea and Hurricanes Harvey and Irma exposed a very large bet against Treasuries by speculators. The bears quickly reversed their short positions, helping to trigger a remarkable rally that pushed 10-year yields to their lows of the year at around 2.015 percent, despite solid U.S. economic data and a vibrant environment for so-called risk assets such as stocks and corporate bonds.


But it soon became clear that the rally left the Treasury market painfully overbought, causing bonds to slump  as yields jumped 27 basis points to more than erase the early September declines. The sudden reversal was capped by the Fed’s stubborn resistance last week to altering its stated path toward boosting rates once more this year and three times in 2018.

The market is now back to a very familiar equilibrium zone in terms of value. Treasury 10-year yields stabilized at the 2.25 percent level late last week, right at the average for the year, before dipping to 2.25 percent Monday amid more saber rattling between the U.S. and North Korea. As such, traders could be in for a return to a low-volatility environment as the effects of Hurricanes Harvey and Irma muddle the economic data and speculators see little sense in challenging the Fed’s guidance.

Two weeks ago, the odds for a December rate hike dropped under 25 percent following five straight months when the Consumer Price Index report disappointed to the downside, signaling low inflation despite a strong jobs market. The September CPI report had to be a relief for Fed Chair Janet Yellen and the other policy makers as it indicated that inflation may be starting to firm up a bit. The odds of December rate increase are now around 65 percent, though there is still a wide gap between Fed’s forecasts for 2018 and beyond and what’s priced in by the market.


Keep in mind that in today’s world, it’s not all about the Fed. While the central bank may have total control over the short end of the yield curve, it has much less influence over longer-term yields. The cheapness of Treasuries relative to bonds in other developed economies is too hard for foreign investors to ignore, resulting in a flood of cash finding its way into the U.S. market. So even though the Fed may be planning to raise rates in December, Treasuries are too hard to pass up when the alternative is German bunds yielding 0.45 percent.


All this foreign money is helping to suppress long-term U.S. rates, causing the yield curve to hold at some of its narrowest levels in a decade while inflation remains dormant. This is a stark reminder that although the Fed can keep raising short-term rates, until inflation accelerates, long-term yields will remain stubbornly low. Although that dynamic will be challenged next year as the Fed’s plan to reduce its balance-sheet assets kicks into high gear, that’s something traders won't be worrying about until closer to that crucial December meeting of the Federal Open Market Committee.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Scott Dorf is a managing director at Amherst Pierpont Securities. He has been selling and trading U.S. Treasuries for more than 30 years.
To contact the author of this story: Scott Dorf at [email protected] To contact the editor responsible for this story: Robert Burgess at [email protected]

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