Bond bears are jumping on the poor result of the US Treasury seven year auction yesterday as a sure sign that the market has priced far too much into this current rally. That may be so but the auction should be seen in the correct context. We have a holiday-shortened week and have already had $81bn in supply from the Treasury in the two year and five year maturities on Tuesday, with very good results from both auctions, especially the two year. So what is happening here?
In our opinion the market is starting to price in the likelihood of a US recession next year and with the slightly weaker industrial production and survey measures pointing to slowing growth, even though unemployment is at a 50 year low, the path of least resistance for the time being is for lower bond yields.
We all know the market often extends itself in either direction with the move up to a yield of 3.25% on ten years last year short lived, just as the move to 1.36% back in 2016 was. If we look at the year 2017 as a whole, only for two weeks did the ten year yield move outside a 2.5% to 2.05% range and this morning we are almost smack bang at the centre of that range at 2.26%. So it could be argued the market is back to fairly priced at this level given all the economic evidence and the continued trade friction.
We think the short end of the curve is where the most optimism is priced in as it appears to be pricing in two rate cuts this year which we feel is too aggressive given the evidence thus far. The longer end of the curve is more reasonably priced as the longer the Fed retains their current pause in monetary activity and does nothing but monitor, the greater the likelihood of a further fall in the inflation outlook, which would again offer the opportunity for lower long rates.