April 24th, 2014 9:05 pm
I have been away from acrossthecurve.com’s sprawling and opulent headquarters today and this is my first chance to check markets and this blog. I just read the end of day piece by Richard Gilhooly at TD Securities (who is a friend and former colleague). He writes a brilliant piece on the “evacuation” of the 5 year point and how it is a precursor of carnage further in on the curve in the 2 year and 3 year. This is a must read and will make you cogitate on the shape of the curve.
Via Richard Gilhooly of TDSecurities:
Having just returned from vacation since the day of the long bond auction, the recurring theme has been out-performance by long duration assets and a mix of higher short/intermediate yields with incrementally lower absolute 30yr yields. In that regard, the new 5yr TIPs issue has traded in lockstep with the 30yr nominal bond, edging lower in real yield as 5yr note yields pushed 15bp higher. The correlation between 5yr TIPs and 30yr nominal should be an inverse one, rather than strongly positive, at least in terms of direction of the long bond.
The curve could be shown to be correlated flatter with higher inflation break-evens, if the direction was higher long rates and even higher 5yr note yields, but the divergence in market direction between 30yr nominal yields and 5yr notes illustrates that the thrust of the trade is more of an evacuation of the 5yr point on the curve into some hedged instrument to avoid the carnage that lies ahead for intermediates (and soon 2yr notes) once Fed tightening moves into the near-term horizon.
However, even in the case of a positive correlation between the curve (flatter–with higher yields across the curve) and higher inflation break-evens, the causality would be a presumption of Fed tightening to ward off those pervasive inflation pressures still bubbling through into TIPs even as yields rise. The opposite was true after the March 19 FOMC (mis?)communication, when TIPs were crushed on b/e after the Fed came out of the hawk closet (partial re-run of last May when Ben rushed into Tapering and shocked the market), which Yellen attempted to reverse with the Chicago talk and again was supported by the FOMC minutes.
Before leaving, I did argue that the minutes were in fact more neutral, that several members suggested the dots would send the wrong signal (so why raise your dot?) but that several others suggested that was entirely the point. On a rationality basis, the hawks definitely won out on that one. Hence, the post-bond auction flattening and again the bid to long bonds as equities recovered off their stumble into tax day and the Nasdaq bounced right off its 200-day.
And the TIPs auction? Buyers scrambled to buy them and paid 5bp through the 1pm level, recognising that they had become too cheap (and supported by April NSA CPI of 0.6%) and had not yet reflected the departure of Stein and Yellen promising low rates for longer. But there is still an inconsistency in long bonds and 5yr Breaks and the question (as it has been all year) is which is more relevant, 30yr yields making successive new lows for the year or 5yr note yields attempting to break higher as PMs exit their under water long carry positions and relocate into the safety of long bonds.
Carry on 5yr TIPs and breaks at the low of the year can explain the short-term foray back into TIPs, with a new 5yr benchmark and a large month-end extension next week. But the persistent bid to long bonds hints at the more fundamental nature of the curve flattening, that the inevitable rise in short rates that will follow the end of QE is the next washout trade and that the time constraints hanging over the Fed, which needs to get rates off the floor before the next economic downturn, is risking lower inflation from a base of already anaemic growth in the current expansion.
The 5yr anniversary of the recovery is June and the driving force behind Tapering and (soon) the need to hike rates is to avoid becoming the next Japan, which ironically raises the chances of that outcome. Escape velocity has not been reached, but the time-out has been called on extraordinary measures.
30yr Bonds and the US Dollar are reflecting this and soon the rally in long bonds will drag 10yr yields under 2.60% as PMs escaping shorter maturities balk at paying up for bonds and load up on 10yr notes, edging down the curve to intermediates. Getting 2yr notes up over 50bp is part of the process, but just like TIPs imploded last summer when they hit an air-pocket, the same is likely to happen to 2yr notes on a break of the 50bp area, followed by a volatile trade to the 1% area in fairly quick fashion.