Last week we noted that we faced a period of instability for Treasuries. Since then, the hit 4.6% last Friday, and today has just hit 4.65%. The overshoot and instability feared is upon us. The big driver? Higher real yields. There are reasons to fear this could be more structural than transitory
The big move up in yields in the past week has not come from higher but rather from higher real yields
The big move up in yields in the past week has not come from higher inflation expectations but rather from higher real yields
From ’We’ve Got This’ to ’Oops, Do We Have This’ on US Treasuries
We noted an overshoot risk towards 4.75% for the 10yr yield. Hitting that has a higher likelihood now that we’ve sailed above 4.5% without material buying. The 4.5% level has been a go-to for global investors as a ’no-brain’ buy area. That’s been taken out. We’re now in a zone that investors would regard as offering medium-term value. Why? As it is comfortably above the average yield of 4.25% realised since 1990, a period that we like to employ as one that contains ’modern’ ups and downs. Simple, but it works.
Key question – at what level will investors decide it’s time to get back in? The problem is that any particular level is fraught with danger, as it is slavish to the extent of closure of the Strait of Hormuz, and that remains a large unknown. We have views on this. See it here. But ultimately, the actual prognosis is driven by the day-to-day vagaries of President Trump and the Iran leadership. Until there is an actual agreement, each day of no agreement offers the Treasury market a vacuum to trade into; logically, a test for even higher yields. It seems the market waited for the US/China summit to conclude, and when it did, without agreement, Treasury yields made their move.
The recent rise in the 10yr yield has come alongside a higher real yield. Inflation expectations had risen, but not a recent driver!
The Remarkable Drive Higher in Real Yields – What’s That All About?
It is worth emphasising that the big up-move in yields in the past week has not come from higher inflation expectations. It has come from higher real yields. In fact, practically the entire break above 4.5% for the 10yr has come from higher real yields. Prior to that, there had not been material net selling of Treasuries at all. Rather, inflation expectations edged higher, and that acted to mark up Treasury yields. No big selling. Just a re-pricing. The Friday post the conclusion of the US/China summit saw that change. There was notable net selling of Treasuries on that day, and that dragged up real yields with it. That has continued as a basic theme.
The fact that higher real yields is a feature gives the higher yields narrative a more sinister feel. In part as higher real yields are often cover for solid real growth. There is a link to the tech boom we currently see. Tentative, but it’s there. Meaning that a reopening of the Strait of Hormuz could leave us with higher real yields anyway. In contrast, a material macro slowdown narrative could gel with a call for a fallback in real yields. But in our view, this is more a risk where the Strait does not open, generating more inflation, and ultimately severe macro angst. In that sense, a reopening of the Strait would cap inflation expectations, but could leave real yields elevated, and if so, then Treasury yields don’t collapse lower as many currently anticipate.
In consequence, an agreement to open the Strait in the coming weeks certainly has the capacity to dampen shorter tenor rates. These are current discounting hikes that may not need to be delivered. Longer tenor rates would fall too, but could find themselves a tad stranded at elevated levels. Real yields could remain elevated, and inflation expectations could prove a tad sticky (they are not particularly high anyway, at 2.5% in the 10yr).
Our Base Case Is Challenged, but in Fact Not Taken Out
It remains entirely conceivable that our mid-year forecast of the 4.5% area is very achievable. The thinking here is a resolution to the shuttering of the Strait in the coming weeks should see a resultant relief rally in Treasuries. Even if we find ourselves in the 4.75+% area at the time, the route back to 4.5% could be swift.
It might prove tough to get materially below that though. We’re calling for it, as an unravelling of the rate hike discount and an easing in the inflation threat could be enough to take us back down to the 4.25% area (but not below, we think).
But that’s for then. For now, we’re undeniably looking up in yield, and we remain in an overshoot tendency. We’ve marked 4.75% as our next staging post. We hold to that, but we still worry that an overshoot risk beyond that to 5% cannot be ruled out (the new uncomfortably high probability risk case). The mood music rhymes with this.
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