Another false dawn, or the real Mc Koy? Yields above 3.00%...

ref :- "Treasuries Sell Off as Investors Assess Tariffs" , The Wall Street Journal, Markets

So what are we to believe ? The 3% yield on the US 10yr Treasury has long been touted as a hugely significant level for investors, both and technically and psycologically. An upward break through that barrier was supposed to point the way to (much) higher yields. In April, the 10yr yield nudged above 3% but failed to follow through. In May it charged through once more, trading as high as 3.11% before falling back again below 3% and severely disappointing the many high-profile bond market bears who were thinking that their time in the sun had come again. (Remember : as bond prices rise, yields fall .... and vice versa). Since that failed upward break in May, the 3% level has acted more as a ceiling than anything else with the rate bouncing off it more than once and as recently as late August trading down to 2.80%

All of which goes to show that whilst we should all keep an eye on technical and psychological levels at all times, we should also be aware that they may not prove to be as significant as we might have expected if the fundamentals are driving the market in a different direction. Anyway, yields challenged the 3% barrier again at the end of last week and as we write are trading at 3.06%, a high since that spike in May. Is it time to ask ourselves whether this move is that one that presages those much higher yields ?

Actually , the first question to ask should probably be "why exactly are yields moving higher when (on the face of it at least) one might think that global issues might be exerting downward pressure rather than the opposite?"

One of the most crucial factors keeping a lid on yields has been the continuing demand for quality government bonds as the ultimate "safe-haven" . Investors search for safe, liquid markets in which to put their money when the world looks like a rocky and dangerous place  --  the scenario known as a "risk-off" environment. With all the trade warmongering and worries about emerging markets, there's been plenty of that going on over the last few months. What's curious about the latest moves is that despite the US / China trade conflict escalating sharply the markets have come over all a bit "risk-ON" . Doesn't seem entirely logical but nevertheless it's pretty undeniable ..... stock markets up, dollar lower, and government bonds lower (which of course means yields higher).

NOTE : Two exceptions : 1. The UK stock market, which naturally tends to react badly to strength in sterling .... as is particularly the case right now as more optimistic noises surround Brexit negotiations. And 2. , Italian Government Bonds (BTPs) in good demand (with lower yields) as leading political figures suggest that their budget to be announced within 10 days will more than satisfy Eurozone rules. The spread between the yields of Germany's and Italy's 10yr debt, which was convincingly more than 300 basis points at it's widest, currently trades at 235bp, or 2.35%. (We're not sure that we have as much faith in the new-found virtue of Italy's leaders as the market seems to have, but still ........)

The rationale behind what some people might view as an upbeat take on things is essentially that it could have been worse. Yes, President Trump slapped tariffs on another $200 billion of Chinese goods but at a rate of 10% .... the 25% rate doesn't kick in until 2019. That may not seem like much of a reason to be optimistic to some people, but the theory goes that it leaves a window open for negotiation  --  and in many instances, a tariff of 10% may not be an insurmountable problem for China. Mr Trump did rattle his sabre about the consequences should China retaliate, and they have duly done so with $60 billion in tariffs of their own .... but in these circumstances, did anyone truly expect them not to ? What the markets seem to have chosen to concentrate on is a welcome reassurance that China will not resort to weakening its currency as a weapon of trade conflict.

To be absolutely frank, it's quite difficult to see how the events of the past seven days have conspired to make markets more of a "risk-ON" environment than they were a week ago .... particularly since there are suspicions that Mr Trump may not be singing from the same song-sheet as his more approachable Treasury Sec Steven Mnuchin. But there are other reasons for a rise in yields ..... not least a heavy supply of corporate issuance in that particular maturity range. It's certainly possible that we are finally witnessing the start of the big move higher in yields, but then again we might have said the same thing a number of times before.

It seems a bit of a leap to call for a big upward leg for yields on the back of a surprisingly relaxed interpretation of events that , if you were of that mind, could be taken as not the remotest bit relaxing at all. You could definitely call it premature. But just as there always has been, there are decent arguments to be made about why yields should go higher, sooner or later : the pace of the economy, the fiscal hole left by tax cuts necessitating more borrowing and issuance by the Treasury, the ongoing process started by the Fed to reduce their balance sheet (effectively placing debt absorbed by QE back into the market).

As to how high yields would go (assuming that they do), the WSJ points out that many do not believe that the big moves higher that some of the big boys have been calling for cannot happen unless and until we see sinificant increases in inflation. As we are often saying, inflation is a killer for longer bonds (prices down / yields up) because it erodes the value of FIXED returns, but the dynamics that drive it have changed. More aggressive inflation as we knew it may be a thing of the past. And if that's true, then the upside for yields may be more limited than some are calling for, whether the current action proves to be significant or not.