The most important developments in the market last week were, not surprisingly, in the bond market.
There were three weak auctions, and yields rose notably. On Friday Treasuries tanked after Bernanke talked about QE, which was notable.
Nomura’s George Goncalves has announced a reversal of the firm’s position, and now sees bonds selling off for the rest of the year:
We have not recommended investors chase this bond market rally since mid- August as the strong move lower in yields has been mostly grounded in speculation of QE and not on economic fundamentals. We were bullish duration on an outright basis for over six months this year, all the way from April’s high in yields to the first touch and go on 2.5% in the last weeks of summer. Since then, we have spent September and October recommending tactical curve and option trades because outright directional rate views have been difficult, to say the least. We realise that market risks remain two-way, but we believe investors should continue to take profits and look for hedging positions for the coming snap-back to higher rates. Although we could be a bit early, this week we are changing our call on the duration outlook and shifting our strategic neutral stance to a bearish outlook for the remainder of the year.
Weak performance in the bond market over the last few days has disrupted what had seemed like, up until now at least, a never-ending race to the bottom in nominal yields. However the benchmark 10-year note crossed back above 2.5% on Thursday after supply indigestion from a string of three weak auctions. This pushed rates higher and suggests to us that the bond rally train that left the station after the September FOMC meeting is running out of steam. One could argue that what we have now is a tale of multiple markets, where TIPS real rates continue to rally while nominals sell-off. At the same time, curves are being bifurcated at the belly point, creating both steepening and flattening moves up and down the curve. That said, rates investors need to re-think instead of rationalizing why various parts of the bond market can go their separate ways. Eventually fundamentals reign supreme, irrespective of policy intervention. In the next few charts we look at cracks in the bond market (looking at Japan and comparing term premia versus forward inflation breakeven spreads refutes some of the misconceptions about the US). Standard relationships in the bond market which will normalize over time – with or without the Fed or other central bank buying – always return as the voice of reason when markets get one-sided.
So, watch for deterioration at the long end, and a widening gulf between 10 years and 30 years.
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