Guy Haselmann: Treasury Bonds, Tactics, and the Fed

Treasury Bonds, Tactics, and the Fed
by Guy Haselmann, Director, Capital Markets Strategy, Scotiabank GBM
My suggestion on October 23rd to tactically convert long 30-year Treasury bond exposures into flattener positions worked well. The idea was to hedge long exposures prior to the FOMC meeting, the GDP report, and the payroll report; and then cover front end shorts after the employment release. The 5/30’s curve flattened 11 basis points over this period. Since Treasuries initially traded lower after the report, ideal execution provided even further gains.

o For active accounts, there will be more opportunities into yearend to implement this tactical strategy again, but negative carry on flatteners makes it less attractive to hold over time.

Treasuries prices have traded a bit heavy at various times recently. This is likely due to heavy corporate bond issuance that is expected to top $100 billion this month. $50 billion was priced last week alone. $12 billion was priced on Monday and $10 billion is expected today. When corporate issuance emerges, end-users frequently sell seasoned bonds to make room for ‘new paper’. Rate-locking activity and subsequent unwinds - at a time when market volumes are low and liquidity compromised - have further added to increased intra-day interest rate market volatilities.

Rate lock flows are likely to dissipate as Thanksgiving/ and year-end approach. Yet, if I had to guess, marginal flow might be supportive going forward as issuers are more likely to unwind hedges, while new supply is likely to fall off sharply after next week.

This week also includes the US Treasury’s $66 billion November refunding of 3s, 10s, and 30s. Treasury supply that is on the calendar and thus is known for a while (as opposed to corporate issuance which unfolds rapidly) is rarely a problem for markets. There is also $59.9 billion in maturing issues, so only $6.1 billion of net new money is required to take it down. The remaining 30-year auction tomorrow should go very well.

The technical charts for long end Treasuries also look attractive. Support levels appear to have held. Key moving averages did not cross or were not violated. The stochastics show over-sold conditions that are now turning up from very low levels. Furthermore, demand over time will continue to outpace supply, helping unloved long end Treasuries march to ever-lower yields.

Markets remain far too complacent in regard to the Fed waiting until June 2015 or later before raising rates. Certainly, carry and roll-down in the front-end is attractive if rates stay on hold for the next 9 months (June) or longer. However, I still believe the Fed at the moment is ‘close enough’ to its dual mandate objectives and should hike rates as soon as it possibly can without ‘disrupting the apple cart’.

I maintain my view that at some point soon the “lower for longer” template will be trumped by a new moniker of “sooner but slower”. I believe the curve will flatten aggressively when this occurs. Since momentum of the US economy has been on an improving path, the FOMC should be setting its sight on where things will be in 18 months’ time due to policy lags.

FOMC members have hinted that wages play a part in their assessment for labor slack and inflationary expectations. One senior Fed official told me earlier this year that wage growth above 3% would begin to worry the FOMC. Well, the Q3 Employment Cost Index report on Oct 31showed wages and salaries rising at an annualized pace of 3.2%. In addition, the details of the Productivity report on 11/06 showed Q3 compensation per hour running at a rate of 3.3% y-o-y. From this perceptive,
the Fed, again, appears ‘behind the curve’.

Could the disconnect between the Fed’s ‘data dependency’ stance and the market’s rate hike expectations be a function of so many frequent shifts in stated policy objectives? Could the disconnect be because the magnitude of the Fed’s stimulus (the last few years in particular) has been far beyond what economic conditions would suggest, leading many to believe the FOMC will continue to stay well ‘behind the curve’?

I doubt the Fed will risk becoming the main source of financial market instability, or risk its independence and credibility to continue down this path. In my opinion, the highest odds, therefore, are for “sooner, but slower”. The longer the Fed waits, the greater are the longer-run consequences, and the greater are the chances that the geo-political and geo-economic situation deteriorates to the point that the Fed misses its ideal window for rate hike ‘lift-off’.

“Lately, it occurs to me what a long, strange trip it’s been.” – Grateful Dead

 

Regards,
Guy

Guy Haselmann | Director, Capital Markets Strategy
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Scotiabank | Global Banking and Markets
250 Vesey Street | New York, NY 10281
T-212.225.6686 | C-917-325-5816
guy.haselmann[at]scotiabank.com

Scotiabank is a business name used by The Bank of Nova Scotia

Download the original version of this report below:

Global Macro Commentary Nov 12

Copyright © Guy Haselmann, Director, Capital Markets Strategy, Scotiabank GBM

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