US Treasury notes: breaking out, breaking bad

Peter Warburton - 27 September 2018

Yesterday’s FOMC meeting marks another step along a cliff-top walk amidst low clouds. Jay Powell’s Fed appears sure-footed and united in its pursuit of an undefined, neutral monetary policy stance, but there are hazards ahead. The Fed has pencilled in another 5 doses of 25 basis point funds rate increases and lifted the so-called terminal rate ever-so-slightly. But the big interest rate event this autumn is a potential explosion of 10-year bond yields in the face of inflation surprises from the domestic labour market, the supply chain and from the volatile crude oil market. Treasury notes depend significantly on international investor support, which the US president seems determined to undermine by his incendiary tweets. The escalation of tit-for-tat tariffs threatens an untimely interruption to valuable supply chains at a seasonally sensitive time.

Returning from a fact-checking trip to New York, I am confirmed in my description of the US economy as a runaway train, as opposed to a locomotive. The destiny of all runaway trains is to collide with immovable objects. However, the economy’s collision with reality may be sufficiently distant to throw fixed income markets into spasm. There are five sources of threat to the comfortable, central-bank sponsored, narrative that sees a 3 per cent 10-year bond yield as an effective market cap.

First, labour market overheating is beyond a joke: the difficulties encountered by retail and leisure firms in hiring seasonal workers presage a jump in entry-level wage rates that will reverberate through the labour market in the coming months. It is proving impossible to fill vacancies without lifting the offer rate. Second, even before the tariff impacts are felt, faster producer price inflation is travelling along global supply chains. Add in the wild card of crude oil prices, where supply uncertainties have scope to deliver another spike scenario, and the prospect of upside inflation surprises is increasingly likely.

Third, under Jay Powell, the Federal Reserve is adopting a gradualist and pragmatic approach to monetary policy that has understandably begun to erode the market’s confidence in the notion of a rate cap. The chairman appears to have no clear destination, only a sense that he will know when it has been reached. Let’s hope it’s on the right side of the cliff. Fourth, while the New York Fed is confident that a faster pace of bond sales will not disrupt the operation of monetary policy, others are less sure. 

Finally, the constituency of enthusiastic net purchases of US Treasuries from abroad consists almost entirely of funds, mainly based in UK, France and in tax shelters (figure 1). Funds tend to trade their positions, so the failure of the attempted late-summer rally in T-notes may already have tilted positions to the short side: this would appear to be message of the speculative positions in the futures market (figure 2). The foreign net sellers, including Russians, Japanese and Indians, look to have structural motivations.
In summary, the US administration has spent the past 21 months calling everybody’s bluff. The outcome is an overheated economy, an inflationary labour market, a tariff war and an escalation of geopolitical tensions that some are characterising as a new Cold War.  In return, international investors have started to call the bluff of the US Treasury market. 


Figure 1

Data source: US Treasury International Capital flows


Data source: CFTC

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