Why I disagree with Bill Gross’ call on the bear market in Treasuries
Until short-dated yields normalize outside the US, curve flatteners are to be avoided, and until inflation returns to the US economic landscape, Gross’ call will remain hot air
THIS year, 2018, is supposed to be the year when the wheels fall off the US dollar-denominated bond markets. No less a market luminary than American billionaire investor Bill Gross baldly stated last week that the 35-year bull market in US Treasury bonds is about to reverse into bear market territory.
Apparently, the trigger for his statement released on Twitter was the breaking of 25-year trendlines on five and 10-year Treasuries. Gross was apparently also less-than-impressed by the Bank of Japan’s decision, taken just before he went public with his bearish call, to taper its purchase of bonds under a quantitative easing programme.
Market participants of a bearish demeanour are watching various tipping points in US Treasury bond yields for confirmation that the decades-long bull market has had its day. The near-term target on the 10-year Treasury is 2.63%, while a longer-term target on the 30-year US Treasury is 3.22%. An all-time low of 2.11% on the 30-year was reached in 2016.
Upside pressure on bond yields was supposed to be exerted by a cumulative US$60 billion to be raised by a variety of sovereign issuers. But the definitive meltdown didn’t happen, despite that pressure. Last week, the US$20 billion auction of 10-year US Treasury bonds went off without a hitch, with primary dealers left short of the bonds they had bid for thanks to solid demand, while in secondary trading the newly minted 10-year had added 1bp to close at 2.56%.
There is no doubt that large sections of the market agree with Gross’s call. The only trade in town for months has been a curve-flattener, a trade conceived out of the idea that while the bid for long-dated paper remains relatively solid thanks to demand from offshore central banks, a steady monetary tightening from the Fed will do the work at the shorter end of the curve. Some are even calling for a curve inversion, a move which has in the past heralded recession.
I disagree with Gross and with all the curve-flattener zealots out there. In the first place, I see no imminent inflationary pressure of a magnitude that would prompt a sell-off of long-duration Treasuries, nor super-aggressive action from the Fed.
The reason is simply the digital transformation which is keeping a lid on inflationary pressures globally and whose power will become hyper-evident to all in 2018. Investment banks, for example, according to a recent piece of analysis by McKinsey, are set to enjoy cost savings of between 20%-30% thanks to digitization. Most corporations that are heavily investing in ICT are going to enjoy similar savings and have no added costs to hand on to their customers.
Meanwhile incoming Fed chairman Jerome Powell is an untested pair of hands, but I doubt that he will slam his foot on the rates gas pedal with unsettling aggression as his term kicks off in February.
And I think the flattener trades which have been jumped on with such enthusiasm will come to nought. The bid on shorter-dated US Treasuries will remain intact while there are deeply negative yields in major government bond markets such as those of Japan and Germany.
A bullish outlook for the US dollar on the back of Trump’s fiscal boost suggests that those Treasuries can be bought on an unhedged basis. Until short-dated yields normalize outside the US, flatteners are to be avoided. And until inflation returns to the US economic landscape, Gross’s call will remain hot air.
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16 Jan 2018