Thoughts on the Bond Market Conundrum

The bond market rally remains among the most significant surprises of the year.  This is especially true for the US Treasury market, which, even if G-Zero hypothesis is valid, remains the critical global benchmark.  Fed tapering was widely expected to push up US yields.  Instead, they have fallen.  The 10-year yield is off 60 bp this year,and nearly half of that decline has been recorded over the past month. Moreover, the US market rally has taken place amid a tick up in both core and headline measure of consumer prices. 

There are many narratives being constructed as journalist; analysts and investors seek to explain this unexpected phenomenon.   While there are many interesting hypotheses, there is a dearth of evidence.  For example, talk of central bank purchases or lengthening maturities is possible, but the data is simply not available to verify or falsify such claims.  The latest TIC data is for March, and foreign officials were net sellers of both bills and bonds.  

Other hypothesis, like speculators, were caught wrong-footed, and the rally in the US Treasury market is a function of their short-covering, is simply contradicted by the facts.  Look at the recent Commitment of Traders report for speculative positioning in the futures market.  In the week that ended May 20, the gross short speculative position in the US 10-year Treasury futures contract rose by 26.1k contracts to 529.4k contracts (each contract has a notional value of $100k).  As of late February, the gross short position stood at 346k contracts.  Their current holdings are the most since late 2004/early 2005.  Rather than reduce short positions, the bears have sold into the rally. 

For their part, the bulls see more life in the rally.  They added 10.4k contracts to lift their gross long position to 436k contracts.  This is the most since last May.  Trend followers and momentum traders have been rewarded as yields have continued to fall.  

There may be something with duration extensions.  Due to the US Treasury auctions and the quarterly refunding, uncommon for the new supply of long-dated note and bonds to prompt industry indices (benchmarks) to lengthen duration.  Money managers who track such indices also lengthen duration.   Reading the entrails of recent auctions, some see evidence for this.  

There has been some talk of investors switching from European bonds to Treasuries recently.  It is difficult to verify it, but the decline of the euro is consistent with this.  Consider that the German bunds have rallied even more than US Treasuries.  This had seen the US premium over Germany widen to 120 bp, which is the upper end that is has offered since 1990.  It has tested this level several times since mid-April and most recently on May 19.  

Incorporating an international dimension is important.  There is a strong possibility of the ECB will take unorthodox action next week.  In anticipation of this, some investors bought European bonds, which, in turn, may make US Treasuries more attractive.  In addition, the Bank of England has tried to convince investors that its rates can also be kept lower for longer.  Many in the market expect the BOJ ultimately to have to provide more stimulus if it is going to achieve the 2% inflation target.  

Another dimension is the regulatory environment.  Banks are being forced to raise capital ratios.  Many banks are increasing their sovereign bond holdings.  As the month of May draws to a close, the Federal Reserve is still buying more long terms securities than it was when QE3+ was first announced in September 2012.  This is taking place in the context of a sharp fall in the US budget deficit.   

This speaks to the relative shortage of Treasuries, but also of other core bonds, like German bunds.  Given portfolio optimiszation strategies and the desire to have core European bonds in global portfolios, there are not a sufficient amount of German bunds.  This forces some large pools of capital, including central banks, to by French bonds as reasonable facsimiles (with the understanding that France, despite it economic and political challenges, remains at the core).   

Back in the mid-noughts, Fed Chairman Greenspan identified a conundrum:  Why are US bond yields falling even though the Federal Reserve was raising short-term rates?  There  were various answers provided, but ultimately none proved very satisfying.  Bernanke, as a Fed governor, suggested, that it was due to surplus savings from Asia and the oil exporters, who did not have the capacity to absorb their own savings.  We now know that European investors were also large buyers of US long-term assets.  

The doom-and-gloom camp warned that QE was going to spark an inflation crisis.  It has not.  Many of the same people argued that the Fed was the only buyer of Treasuries.  No one else would buy them.  This too has proved wide of the mark.    Evidence for most explanations seems to be sorely lacking, and there are likely to be more than one cause.  Many have cited activity by central banks and sovereign wealth funds, which seem all too often as the go-to-explanation.  We would place emphasis on private sector participants and technical and regulatory issues in the context of the Fed and BOJ's ongoing significant purchases and anticipation of ECB action.