What a difference one month makes. Recall that rates and rate-sensitive equities were all the rage in January (returns through the JAN 30th YTD trough in the 10yr Treasury note yield):
- iShares 20+ Year Treasury Bond ETF (TLT): up +9.8%
- Vanguard Extended Duration Treasury ETF (EDV): up +14.3%
- iShares National AMT-Free Muni Bond ETF (MUB): up +1.6%
- Utilities Select Sector SPDR Fund (XLU): up +2.3%
- Vanguard REIT ETF (VNQ): up +6.9%
Compare those YTD returns to that of the SPY over that same duration: down -3%.
Returns since JAN 30th:
- TLT: down -8.5%
- EDV: down -12%
- MUB: down -1.8%
- XLU: down -5.4%
- VNQ: down -2.2%
Compare those returns to that of the SPY since JAN 30th: up +5.9%.
We think two factors have combined to perpetuate this dramatic reversal:
- MASSIVE capitulation across the consensus Treasury bond bear community
- MEANINGFUL accelerations across the spate of Q1-to-date high-frequency growth data that actually matters (we don’t have enough time to waste your time flagging deviations in the Empire Manufacturing or Philly Fed Indexes)
Regarding point #1:
- Recall that the 10yr Treasury note was the most shorted asset across the entire buy-side coming into the year.
- The net short position of 277k futures and options contracts for the week ended DEC 23rd was over three standard deviations below its TTM average at the time.
- In a nearly-straight line, that net short position was reduced to 83.8k by the week ended FEB 10th. That figure was roughly equivalent to its TTM average at the time.
- This short-covering helped to perpetuate that 1.64% print on the 10yr Treasury yield we saw on JAN 30th.
- The net short position has since widened to 125k though the week ended FEB 17th; prices have reacted violently to the downside amid what is now a less-crowded trade.
Source: Bloomberg L.P.
Regarding point #2:
- Just about every meaningful economic data point we’ve received in the quarter-to-date that corresponds to 1Q15 has shown either a positive inflection from a trend of deceleration or incremental acceleration throughout 4Q14/2H14.
- Ironically, the one that showed sequential deceleration (JAN Nonfarm Payrolls) was arguably the one that perpetuated the most upside in Treasury bond yields.
- This was due to MASSIVE revisions to NOV and DEC Nonfarm Payrolls growth, meaningful accelerations in income growth and increased labor force participation – all of which combined to make the JAN ’15 Jobs Report among the best we’ve seen throughout the recovery.
- Moreover, in spite of the downtick from nearly “uncompable” growth rates, Nonfarm Payrolls themselves continue to accelerate on a trending basis. The revised NOV and DEC MoM growth rates of +423k and +329k, respectively, were in the 99th and 94th percentile of all readings over the trailing 10yrs.
- The U.S. labor market is in the “sweet spot” of late-cycle strength. How long this lasts is beyond our ability to forecast, but historical trends would suggest that we have at least ~2 quarters left before it semi-permanently inflects. Nothing in the Jobs Report itself or in the Initial Jobless Claims series is suggesting the U.S. labor market of ~140 million employees will turn on a dime and negatively inflect in the near term. If it does, this time will, in fact, “be different”.
- Specifically, the 2nd derivative of NSA Initial Jobless Claims is once again showing accelerated improvement in the labor market after more or less stalling for ~6 months.
- Arguably the most misunderstood economic release in the quarter-to-date has been the JAN Retail Sales figure. While soft on a headline basis relative to consensus expectations, the YoY growth rate of the control group – which is easily the most important figure to watch if you model GDP on a YoY basis like we do – accelerated +100bps sequentially to +4.3% YoY.
- Industrial Production showed acceleration on sequential and trending basis in JAN.
- PMIs positively inflected from their trend of deceleration in JAN and FEB.
- Consumer Confidence and Business Confidence each ticked down MoM (in FEB and JAN, respectively), but both indicators continue to accelerate on a trending basis.
All told, a flurry of #Quad1 data has left us clearly on the wrong side of this gigantic counter-TREND move in rates and rate-sensitive equities for the month of February. We won’t apologize for it; instead, we’ll focus our efforts on how to best position ourselves from here.
While our intermediate-term TREND view that long-term interest rates test their all-time lows (likely sometime in 2H15) remains unchanged, we do think the next 1-2 months could continue to provide intermittent and/or violent headaches for bond bulls if the economic data continues to be reported in line with our GIP Model’s forecast of a #Quad1 setup in 1Q15:
As such, appropriate risk management – be it reducing one’s gross and/or net exposure to this trade, actively trading in/around positions, etc. – is undoubtedly required to stay afloat amid rising volatility in the fixed income markets; on a trailing 3-week basis, the MOVE Index is now trending at its highest level since SEP ’13.
Source: Bloomberg L.P.
Will the FOMC proceed with a rate hike in 2015? Who knows. It is worth noting, however, that both the market and the preponderance of data would seem to suggest the probability of a rate hike is low and falling.
That said, however, their insistence on being hawkish almost seems token/politicized at this point. They might just do it if for no other reason than to create some semblance of a policy buffer before the next recession. It’s trivial to state that there will be a “next recession” at some point in the not-too-too-distant future.
At any rate, while an explicitly hawkish Federal Reserve is clearly not good for Treasury bond bulls like ourselves, we think such a gesture might present investors with the buying opportunity of a lifetime:
- A stronger U.S. dollar will only exacerbate the global deflationary forces we’ve seen over the past ~6 months.
- Moreover, by the time the Fed gets around to actually hiking the Fed Funds Rate – if they even elect to do so – the peak of the economic cycle will almost assuredly be in spitting distance. The Fed hiking rates into an economic downturn is not exactly the best thesis for a sustained bear steepening of the yield curve.
- At the bare minimum, the ECB and BoJ will likely be forced expand their respective LSAP programs in order to combat another leg down in their respective inflation readings. That would likely put further pressure on German bund and JGB bond yields, which would likely perpetuate incremental fund flows into the Treasury bond market. Total inflows into U.S. Bond Mutual Funds and ETFs has averaged +$5.72B per week in the YTD, which is nearly triple the rate of +$1.96B per week in 2014.
Source: Bloomberg L.P.
Source: Bloomberg L.P.
Best of luck out there risk-managing this duration mismatch.
Have a great weekend,
Associate: Macro Team