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Where US Treasuries are headed

Caught between the Fed and the president
February 7, 2019

Jerome Powell was hand-picked by Donald Trump as chair of the US Federal Reserve; by October 2018, following further incremental rate rises in the target Fed funds rate, a spat between the two had broken out in the Twittersphere. It appears that the president has now extended an olive branch, this Monday inviting Mr Powell and his deputy Richard Clarida to an informal supper at the White House, which included Treasury Secretary Steven Mnuchin.

Since 2016 the Fed has been slowly hiking the Fed funds target from 25 basis points to 250. Meanwhile, since 2014, the US Treasury yield curve has been flattening, the spread between two and five-year paper dropping from 140 to 10 basis points, that between the two years and 10 years from 260 to 11 pips, suggesting bond market professionals are ignoring the Federal Open Market Committee (FOMC), or that they consider the tightening wrong. The Fed stopped abruptly and unexpectedly (for some, but not the bond vigilantes) on 30 January 2019.

The impact was felt most sharply at the short end of the US Treasury note curve, where two-year yields dipped from 2.62 per cent to 2.45. Of far greater interest is that this same paper saw yields peak at 2.97 per cent in early November 2018, plummeting all the way down to 2.37 at the beginning of this year. This is a good example of markets discounting future newsflow, economic trends and investor appetite. Markets don’t need ‘certainty’ to go forward, they hazard a guess, work out the odds, and go for it.

The change of tone in Q4 2018 was then confirmed by Mr Powell in the FOMC minutes last Thursday, rippling through fixed-income markets across much of the globe. A function of modified duration, the biggest basis points move was to be found in bonds with the longest time to maturity; yields now at their lowest in a while. Thus 30-year US Treasury bond yields slumped from a 3.46 per cent to 2.88 per cent. In terms of the monthly chart pattern of the past year, it looks like another broadening top formation (see last week’s column) and looks set to cap the back-up in yields that started in mid-2016.

 

The impact on Wall Street of this potential change to the path of interest rates was muted: the damage to the S&P 500 index was done in Q4 2018, bigger than that in February. In fact, the bulk of the slump happened between Thanksgiving and New Year, caused by holiday-thin markets. Lesson to all of us: sort yourself out before you go on holiday. January’s strong bounce, correcting a Fibonacci 61 per cent of the previous collapse, is due in part to the rates outlook, but is more a sharp reaction to the elastic band that was stretched too far down in December.

 

Today this, and some other major indices, are trading roughly in the middle of the slightly unsteady, top-heavy range that dominated much of last year. The rally is clearly corrective rather than a new impulsive wave – for now at least. We are trading under the 200-day moving average, which lies above the 50-day one – another bearish sign. For the first time since Q1 2016 we are trading below the weekly Ichimoku cloud that had supported the rally through to October 2018. It looks to cap price action until the summer.