So why wasn't there a strong reaction in the bond market if inflation is starting to surprise on the upside?
We believe that where a complicated market becomes even more so, is when one considers 1.) the relative extreme in yields that was reached at the end of last year, 2.) the uniqueness of the capital markets relative to what the Fed has provided over the past five years; and 3.) the rear-view proximity, density and casualties in participants memories to the spectrum of financial bubbles and crises from LTCM to GFC.
All told, we believe current market conditions will at the very least place a governor on the impetus for rising long-term yields despite the fact that inflation is starting to pulse strongly through the system.
#1 - Relative Extreme
While we have never claimed to be experts on the nuances and intricacies of the US Treasury market, we do bring a thorough historic evaluation of trend and performance of some of the larger asset pistons and gear exchanges that help propel the system forward. Broadly speaking, this provides a comparative bearing to triangulate market strategy from of what we believe lies just ahead on the horizon. Going into 2014, we anticipated that long-term Treasury yields would pull back from the relative extreme they notched at the end of last year. Despite their historically low disposition, the talk of the taper that began in earnest last May spooked the bond market and elicited a rally in yields -- the surprisingly magnitude of which was likely discretely lost on many. Here's a quick snippet from a previous note that sets the stage.
...Even when contrasting the bond market carnage in 1994 - brought on by the commencement of an unexpected Fed tightening cycle, the move in 10-year yields over the past year has been twice its magnitude. When viewed as a comparative study between these two time periods (normalized below by the month over month performance) you can see that even during an actual Fed rate tightening period in which the fed funds rate doubled from 3% in February of 1994 to 6% in February of 1995, 10-year yields crested only ~ 40% above the previous years low and started breaking down during the Fed's final rate hike in February of 1995. To put the move in even greater context, 10-year yields appreciated just shy of 70% from the entirety of the previous cycle low in June 2003 to the cyclical peak in June 2006. This encompassed a Fed rate tightening cycle which took the fed funds rate gradually from 1.0% in June 2004 to 5.25% in June 2006... - Perspective 4/30/2014
Where that leaves us currently is in the doldrums between the downside pivot in long-term yields
that began at the start of this year and the next move we still expect will be lower along the arc of the 1995 return. Helping things through the pivot this year has been a consistent imbalance extreme with respect to sentiment and positioning in the long-term Treasury market. E.g. at the start of the month with the move in the 10-year yield falling close to 20% to ~ 2.40% for the year, a J P Morgan Chase & Co (NYSE:JPM) client survey indicated the difference between the number of investors who said they are bearish on US long-term Treasuries exceeded those who are bullish grew to its highest level since May 2006 -- one month prior to the previous cycle peak for yields in June of that year.
#2 - The Hand of the Fed
While most market research has been fixated on comparative bearings with more recent Fed rate tightening cycles and when the Fed would commence this rate tightening regime, they have largely
panned the one historic market environment that shares the closest parallels with the long-term yield cycle (a market the Fed has little control over) and the underlying skeptical and skittish market psychologies that defined the body politic of the market in the 1940's. Why? Ignoring the fact that it was the last time the Fed conspicuously supported the Treasury market and when long-term yields were troughing on the mirror of the cycle, it falls across the narrow window of WWII and the signing of the Treasury-Fed accord of 1951. A period apparently too dissimilar for economists who have collectively been taught to build their reference coordinates of peacetime market stability from periods after the Bretton Woods system was scuttled by Nixon in 1971. Moreover, it was a period where the Fed did not raise rates as market expectations gradually normalized from a time period defined by repeated Fed and Treasury interventions.
Over the past several months we have drawn parallels to both the equity and Treasury markets of the 1940's (see Here ) and believe the current market environment rhymes much closer with this time period than the more recent Fed tightening regimes we see referenced daily. On one hand, we are reminded that this isn't the 70's, where long-term yields rose rapidly with inflation expectations - and this isn't the pre-ZIRP periods of the 80's, 90's or even this centuries first decade which enjoyed a fed funds rate that could maneuver on both sides of the road. No, this is a place we have playfully referred to as Esoterica -- an unfamiliar territory for several participant generations that we have found the closest parallels with the troughing long-term yield environment of the mid 1940's.
Another major parallel, which dovetails into our third point is the fact that the only other period in which the Fed actively intervened and bought the Treasury market in support of the broader system was in the 1940's. Similar with the current lackluster fundamental backdrop that has diverged over recent years from the stoic strength of the equity markets, the massive bond buying program in the 1940's had a much stronger correlation to the capital markets it directly affected than the macro climate that most economists appraise.