A longstanding puzzle for portfolio managers is how to assess market sentiment in bond markets – treasury futures provide a way of doing so. These instruments are often used as a hedge in fixed income portfolios against losses if T-Bill prices fall significantly. The mechanism is straightforward: short sell a treasury futures contract and buy it back at a lower price to exit the position at a profit. Recently, the value of short positions was recorded at $140bn in February, while the number of contracts hit an all-time high of 580,000 in April. This indicates bearish sentiment in the T-bill space at a level never reached before in the market for the ‘safest’ asset. Most of this is driven by interest rate and inflation expectations. The Federal Reserve officials, including Chairman Powell, have often pointed to accelerations in inflation over the last four months, particularly due to the tax cuts and rising oil prices which could point towards a quicker rise than the markets have priced in. Currently, markets have priced an 86% probability of a June rate hike. Eric Rosengren, the Boston Fed President, made it clear last week that risks to the economy are twofold; on the one hand aggressive trade protectionist policy could lead to a decline in the incomes of the export sectors (making up a large part of the Dow Jones index) due to retaliation by trade partners. This would dampen growth and inflation in the medium term.
However, cost-push pressures weighing on the inflation rate and, in particular, higher wage growth from low unemployment, could lead to faster rises in the interest rate to curtail tail risks in inflation. The Federal Reserve is treading a tightrope; to avoid disruption to markets, officials constantly voice the stance of the Central Bank so as to influence expectations of steady rises in the interest rate. However, the risk of headwinds in the wage growth, oil prices and domestic investment due to tax cuts could lead to inflation outpacing the planned rise in interest rates.
Short-term bond auctions have been at all-time highs this year to plug the US government’s budget deficit, which has put downward pressure on prices – however, foreign demand has been weak, particularly from Japan. Foreign investors are not convinced by Trump’s economic model of maintaining high budget deficits and threatening trade wars, and as such, these auctions have been met with weak demand. This is also putting upward pressure on yields at the short end of the curve, adding to investor expectations of rising interest rates over the next 2 years. Lower foreign demand has also contributed to Dollar depreciation; a weak currency typically also leads to higher bond yields due to the outflow of short-term foreign capital that occurs in anticipation of exchange losses on conversion back to home currency. The flattening yield curve is evident by how the spread between the 2-year and the 10-year note yield has narrowed to 46 basis points, the tightest since September 2007.
For now, however, the long end of the yield curve does not seem to reflect expectations of persistent inflation over the next 10-30 years. 10-year yields have only fallen 17 basis points on average since the start of this year, compared to an 80-basis point rise in 2-year yields; this suggests that the flatter yield curve has been fundamentally driven by inflation fears and interest rate expectations over the short term. Investors should watch the auctions of Treasury bonds to take advantage of any further flattening; yields did decrease at the long end in the last 2 months of 2017 after the Treasury announced that there would be no further auctions of 30-year bills till 2018.
In conclusion, the bond market has experienced volatile movements since the start of 2018 due to the radical fiscal policy changes and fluctuating monetary policy expectations based on the guidance provided to the market. It is most important for investors to analyse the market sentiment and the drivers of the yield curve’s shape in order to make informed decisions about rebalancing portfolios or take advantage of profit opportunities through trading the spread. While the yield curve is at its flattest in a decade, risk-tolerant investors taking short positions in the market should be warned that markets are in a volatile state; any unforeseen shocks to economic growth or dovish statements by the Federal Reserve chairman can lead to a reversal in the Treasury futures net short positions and a steeping at the short end of the yield curve.
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