On Tuesday morning, I saw several references to a large investment house warning that the market is ill-prepared for the coming Fed hikes, and that bond yields are on the cusp of soaring higher with the supposed prospective string of central bank rate increases. Scary, eh? I think I have been seeing this argument for at least six months, from various investment banks. However, the argument has been wrong, and is likely to continue to be wrong. I am not saying that it’s completely implausible to get a bond sell off, what I am saying is that it is not at all likely to occur due to Fed hikes. In fact, a move to higher yields on the long end, should it occur, is much more likely to come as the result of the Fed being on hold.
Why would I make such a heretical claim? Because I am watching how the market ACTS, not how I think it SHOULD ACT. For example, in the last two months of the year, the ten year gov’t yield averaged around 2.25%. The Fed instituted its first rate hike in mid-December. What happened since then? The yield has FALLEN 50 bps since, closing Tuesday just under 1.75%. But that’s because of China right? Sure that’s part of it. But consider what happened on Friday. CPI was released with Core yoy up 2.2% ( ! ) above the Fed’s threshold of 2%. Core CPI has actually been edging slightly higher for a year. Analysts began to say that the Fed’s tightening campaign was back on track after having been called into question because of stock market jitters. However, all that really happened after CPI is that the curve flattened. On Feb 18, 2/10 treasury spread closed 104 bps, and in the wake of Friday’s CPI it is now below 100 bps, the lowest since 2007. To quote from Trains Planes and Automobiles, “You’re going the WRONG WAY.”
Let me give you an example of bonds reacting to Fed hikes. It was January 1994. The Fed Fund target had been locked at the then historical low level of 3% for a year and a quarter. The ten year note yield was oscillating around 5.75%. There was a surprise 25 bp hike in February 1994, followed in rapid succession by hikes in March and April of 25 bps each, and then 50 in May. By May the ten year yield hit 7.5% and by September, 8%. Now that was a move! (which led to the Mexican peso Tequila crisis, but that’s a story for another time). Or even consider the taper tantrum of May 2013. When Bernanke suggested tapering might occur, the ten year yield exploded from 1.70% to 3%, and this was in absence of any change at all in the Fed Fund target.
Let me repeat. Long end treasury yields in the US are not going up, and probably will not make a meaningful move up until the Fed cries uncle and clearly communicates that they are on hold, or are leaning towards more stimulus.
Just watch how the market trades, don’t listen to the experts that are studying the old road map. In the words of Del Griffith of American Light and Fixture, Shower Curtain Ring division, “Oh he’s drunk. How would he know where we’re going?”