Tantrum…NOT!

An article on Bloomberg the other day cited Deutsche Bank analysts predicting a “baby tantrum” in bonds in 2016.  “[Dominic Konstam] predicts the Fed will catch bond traders wrong-footed by raising rates in March.”

http://www.bloomberg.com/news/articles/2015-12-26/deutsche-bank-sees-taper-tantrum-echo-ahead-for-u-s-treasuries

While I do agree with another point in the article, that volatility is likely to increase, the mini tantrum argument simply doesn’t have legs.  First, consider the near Eurodollar contracts.   EDZ15 contract settled at 99.4822, having completely priced the Fed hike which was to occur two days later on December 16.  Even if one makes the argument that EDZ15 didn’t completely price the hike, the LIBOR setting on Dec 17 post-hike was 57 bps, a price equivalent of 99.43 and only 5 away from EDZ15. There is an FOMC meeting on March 16, 2016, two days after the expiry of the EDH16 contract.  On Tuesday, EDH16 was trading 99.25 or 75 bps.  If the market was FULLY convinced of a hike at the March meeting, then EDH16 should trade about 25 bps lower in price (or higher in yield) than the EDZ15 contract.  In other words, EDH16 would trade 99.23 or perhaps 99.18 as an outside low.  It is painfully clear that EDH16 embeds fairly high odds of a hike at the March meeting in its current price.  How can one be caught “wrong-footed” when prices are already reflecting a 3 out of 4 chance for a hike?

In addition, consider the chart below of the Five year Inflation Indexed Note (TIP).  The yield on this instrument is considered a “real yield” as the holder gets a payment based on CPI in addition to the coupon.  When the true taper tantrum hit in 2013, the 5 yr tip yield started at MINUS 175 bps.  By September it had surged to zero.  Now THAT’S a tantrum!  Currently the 5 yr tip yield is above 47 bps, near the high of this year, and indeed as high as it’s been since 2010. In 2013 this yield was like a beach ball held under water.  It’s now bobbing along on the surface.  There is very little reason to think real yields are going to jump, and with most commodities at multi year lows, it’s a bit hard to see an inflation surge.

AlexDec30.JPG

Finally note the 2/10 year treasury yield curve spread.  At 121 bps it’s near the low of the year.  The curve has flattened since the hike.  In other words, the long end of the market has absolutely no fear of Fed hikes, on the contrary, the market believes further increases will slow the economy and inflation (which is already apparent from recent soft data). 

If there’s to be a tantrum in the long end, it will be much more likely to occur in conjunction with a Fed that signals no more hikes, in which case flatteners will be covered and bonds may begin to once again have some sort of a term premium in their prices.

Alex Manzara

www.chartpoint.com