August- could be described as a mad month so far.
Price action in Core Government Bond markets this week has been very negative to say the least. The biggest moves have come in the US with Us Treasury 10yr yields rising 18bp from last Friday’s close and 30yr yields higher by 20bp.
What has been the reason behind this. In talking to US Treasury dealing desks most have signaled that they have seen little flow to justify the moves.
The start of the movement higher in yields came after the US Retail Sales data for July which came in higher than market analysts expectations. However, the June data was revised lower, and means that the US Q2 GDP expectations should be cut. The surprise in July’s Retail Sales Data was across the board and whilst higher Fuel prices would have been a factor, it is not a major factor here. But the rise in Retail Sales for July from June cannot be seen as strong enough to justify the yield rises in the US bond markets on their own.
One result of the Retail Sales data was that the expectation of QE from the FOMC in September was reduced. Goldman Sachs produced a Research document ruling out any chance of QE3 in September.
This reduction in expectation of additional US Stimulus from the Fed has led to an increase in turnover of the TBT ETF. This ETF is a synthetic short in the 20yr area of the US Treasury curve and is 2 times leveraged. The turnover over the past 2 days in the ETF is nearly twice the 20 day average. The ETF will use futures not cash to synthetically position itself- and this is where the price action in US Treasuries is occurring. Again futures turnover has been above the average for this time of year. It is not in the cash market. This ETF is not going to be used by institutional investors. It is a Retail Investor’s product. So I would say that the US Treasury sell-off has come from US Retail Investors speculating that the lack of QE3 will see a rise in US Treasury yields.
The lack of institutional activity is due to this week being one of the busiest holiday weeks of the summer. Treasury dealers did report huge investor voids when Futures prices were falling. No one stepped in. And yet the investor surveys did not show large scale in imbalances between long and short positions. Institutional investors have been relatively inactive this week. It has led to the one directional trading seen.
The reduced expectation of QE3 has also been seen in other Retail dominated markets– Tuesday and Wednesday saw Gold fall $20 – before talk of Hedge Fund manager Paulson taking an even larger position in Gold spurred a recovery in prices.
But the price movements are not driven by changes in the fundamentals.
The rise in Treasury yields would normally be driven by a rise in inflation expectations and if the move in yields was driven by institutionally selling then the TIPS market would normally outperform the nominal markets. And yet inflation breakevens have hardly moved all week and are actually lower from last Friday currently.
The lack of movement in commodity markets continues to put a dampener on inflation breakevens. Metal prices continue to be depressed and signs from China continue to suggest that the economy there is slowing and commodity prices will remain subdued. So inflation fears are not the reason behind the back-up in US Treasury yields.
But- the Retail investors are right about the chances of QE3 being reduced.
This week’s release of the Empire State Manufacturing report and the Philadelphia Fed Business Outlook both signaled a manufacturing economy slowing and should mean the August ISM data will remain below 50 for the second time. Raising the prospect of an even weaker Q3 GDP than the current 1.5% Q2 .
And the Fed has little room to move. Both Fed surveys showed rises in price expectations and show less deflationary expectation than 2 months ago. As such the arguers for QE3 inside the FOMC will not have that on their side.
The fact that QE3 is unlikely at the September FOMC meeting should rule it out for the rest of the year unless a financial disaster in Europe forces the Fed to act.
But the lack of any further monetary stimulus when the economy is showing signs of slowing to below 1.5% Annualised GDP Q0Q must impact risk markets and make US Treasuries attractive again. The low growth environment is here to stay and will mean continued zero interest rate policies in the G3 economies.
That is a positive environment for US Treasuries in particular.
So I would expect that as more and more institutional investors return from their holiday homes, I would expect to see the return to yields significantly below the current levels and as growth expectations are lowered even more , 10yr yields should move below the historic lows of 1.38% seen just 3 weeks ago.
It’s not luck perhaps we need here, its realisation from others.