Nomura Explains What's Behind The 'Seismic Break' In The US Treasury Market

Let’s start this post with a chart we’ve probably run about 20 times this year.

If the year ended now, it would easily be chart of the year.

It’s a 5-year look at 10-year Treasury yields (red line) vs. the S&P 500 (blue line).


Photo: FRED

What should be instantly obvious is that for a long time, the two lines moved very closely together.

When the stock market would rally, yields would move higher. When the stock market fell, yields moved lower.

And the explanation is fairly simple in that a rising stock market indicates growth and confidence, and when people are feeling growthy and confident, they take money out of risk-free assets like Treasuries, causing rates to rise.

So it’s been a headscratcher that since late last year, the pair of lines have become divorced.

One popular theory is that it has to do with the Fed engaging in operation twist, and perhaps threatening to do QE3, but this theory isn’t that compelling. For one thing, we’ve already had two rounds of QE, and in neither instance did the lines divorce like this, and it’s not totally obvious what it is that’s new and different now.

But something has changed in the last few days. You can see it easily on the above five-year chart, but yields on the 10-year have really started to surge. Here’s a look.


Photo: Yahoo Finance

Last week, 10-year yields were below 2.00%. Today they got close to 2.30%. The yield would still have to shoot a lot higher to catch up with stocks in the above chart, but the gap is narrowing a little bit.

So what’s happened?

Well, we really like the theory put forth by Nomura’s rates strategist George Goncalves in a note titled: The Perfect Storm to Push us to Even Higher Yields?

He writes:

UST yields had a seismic break and have finally moved this week, and boy did they move. The market blew through the range it had held for the past four months, our near-term targets and through several important technical levels, all in the space of two trading sessions. The market traded with significantly negative convexity, as four months of bad positions (“trapped longs”) started to get washed out. This was coupled with a break of the general complacency in broader markets where EM and MBS spread investors were under-hedged for their duration exposure, and they were forced to cover too. In that light, a pullback or consolidation is not a given by any means, and the possibility for a rapid move to the fair value of 2.40% (and an overshoot higher) is possible.

So what’s his explanation for the “seismic break”?

Basically, he sees the clouds continuing to lift in Europe.

EUROPE HEDGES UNWOUND: While stocks sold off on the day, the key markets we were monitoring were the peripheral bond markets in the eurozone. One of the themes we have repeatedly mentioned has been the sizable investment by euro-area money managers into USTs while being underweight their domestic bonds. We find it instructive that the significant selloff started during European hours and was accompanied by spread tightening across peripheral and semi-core sovereigns (despite supply), and welcome early signs that these flows have started to reverse.

So the basic gist here is that while things have been improving for a while — arguably since the announcement of the first LTRO late last year — the world has been ‘overweight’ US Treasuries, while investors have been underweight their own markets.

That’s starting to shift, and that’s causing some of the permanent bid to come out of US Treasuries.

And again, that theory is consistent with what we’ve seen elsewhere. The big selloff lately in the Japanese yen is consistent with hedge funds, who are inclined to borrow in yen as part of the carry trade, extending their borrowing, and re-risking their portfolios (this is a concept that was explained in a recent note by hedge funder John Taylor).

So basically, the most crowded safe-haven trade in the world is coming unwound, and people are getting back to buying more normal, risky assets. The move might be described as “seismic” but it doesn’t mean it’s bad.

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