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Compelling cyclicity

Compelling cyclicity

23-04-2021 | Graph of the week
Financial markets can be unfathomable at times. We saw an example of this last week, when the 10-year Treasury yield fell to 1.54% in response to very strong retail sales in March. These exceeded consensus expectations by percentage points, with an annualized increase of 9.8%.
  • Peter van der Welle
    Peter
    van der Welle
    Strategist Global Macro team

The graph below shows why that response has left fundamental bond investors who tend to look at things through a macro lens scratching their heads. The orange line represents the macroeconomic surprises in the US. In other words, the extent to which economic data departs from the consensus among economists.

Index values that are positive suggest that the economic data in the US surprised on the upside at the time, negative values show the economic setbacks. The turquoise line is the real 10-year Treasury yield change on a quarterly basis. What can be seen is that in the past ten years, both lines have usually (but certainly not always!) moved in the same direction.

Higher macro surprises imply a higher real yield, and vice versa. This relationship is economically intuitive as well. The stronger economic growth seems than initially expected, the greater the compensation demanded by bond investors for growth risk.

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Overview

Explanations aren't correct

But that positive correlation didn’t apply last week, for which different explanations have of course been given: the bond market's response was allegedly more modest now because yields already rose sharply in the previous quarter, which in turn was the result of historically high economic surprises at the start of the quarter (see the peak in the orange line).

While a somewhat lackluster market response to continued positive news is understandable, this explanation doesn’t hold water owing to the fact that the correlation was suddenly negative last week instead of ‘just’ less positive.

Another explanation is that recent communication by the US central bank (interest rates will remain low, even if the economy is at risk of overheating) has managed to convince the market. But this argument also falls short, because it doesn’t explain why there was an immediate response following the publication of the strong macro data. The pricing in of Fed forward guidance is usually a more gradual process. The saying, ‘Trust takes years to build, seconds to break, and forever to repair’ holds for the Fed, too.

Technical resistance

Sometimes fundamental explanations just don’t suffice. That is why in addition to the macroeconomic perspective, an investment process should always take into account valuation, sentiment and technical market factors as well. And in this case, a technical cause seems to be dominating the market.

The black line illustrates a 0.4% increase in the real yield on a quarterly basis. In the past ten years, this has also been the resistance level at which the sell-off in US Treasuries (and thus rising bond yields) invariably lost momentum. We saw that in July 2015, in November 2016, in February 2018, in November 2018 and in March 2020. The big exception to this is the infamous ‘taper tantrum’ in June 2013.

Now, like then, the bond market appears to be rebounding at around 0.4%. It seems, therefore, that real yields rose too sharply in the last quarter – possibly due to profit taking by market participants on the short side of the Treasury trade and an increased repositioning on the other side of the trade. Based on CFTC data, for example, hedge funds have again taken a net long position in US Treasuries now.

What goes around comes around

What is striking, is that despite increased speculation on the prospect of a long-lasting bear market in government bonds, cyclical pricing and positioning still seem to abide by the laws of bull markets in recent decades. Cyclicity compels.

Technical factors will likely lose ground to more fundamental factors after this period of consolidation. The reopening of the US services economy is in sight and there will be a higher demand for capital by both the private and the public sectors, to meet catch-up demand. A number of cyclical sources of inflation (bottlenecks in supply chains, higher commodity prices, greater mismatch between supply and demand on the labor market) are also starting to make themselves felt.

In short, the market will ultimately demand a higher reward for growth and inflation risk in the near future, leading to a further rise in US Treasury yields.

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