The term premium red herring

About a week ago, market anxiety was high over surging Treasury yields, which was attributed to concerns over a soaring fiscal deficit and a rising supply of Treasury paper. This led to upward pressure on the term premium, or compensation for holding longer duration assets, and real yields.

 

Here’s what has happened since the peak in rate anxiety. In the space of a week, the market had to face a blowout jobs report, a surprise Middle East war, and hot PPI and slightly hot CPI prints. In the face of such news, one would think this would put upward pressure on yields. Instead, Treasury yields retreated.
 

The fall in yields was initially attributable to a flight to safety, but such an explanation doesn’t seem plausible as the USD Index fell in lockstep. If there had been a flight to safety, the USD would have been bid.

 

What happened? The most reasonable explanation is that the jitters over rising term premium and real rates was a red herring.
 

 

A matter of psychology

When I discussed this issue last week, I concluded, “I believe the market is at or near the point of maximum pain and investors should be prepared for a FOMO scramble for bonds and risky assets.” I stand by those remarks.

The change in market tone can mainly be attributable to market psychology. Bond market sentiment had become excessively bearish. The concerns over the fiscal deficit and Treasury supply are nothing new, as these factors are well-known.

Instead, large speculators, or hedge funds, had taken a crowded short in both the 10-year T-Note and 30-year T-Bond, which is contrarian bullish. When the market took a risk-on reaction to the strong employment report, it was a sign of bearish exhaustion. Jay Barry of JPMorgan Chase revealed in a Bloomberg podcast that the 10-year Treasury yield was 35–40 basis points over their firm’s estimate of fair value. When psychology reversed, yields fell.
 

 

 

Higher for longer?

At the height of the bond market panic, I privately pondered at what point would the Fed come to the rescue of the Treasury market in order to prevent a disorderly unwind in the manner of the gilt crisis of 2022. Since then, various Fed officials have spoke and given dovish guidance.

Dallas Fed President Lorie Logan, who is considered to be a hawk, gave the clearest indication of the Fed’s reaction function to rising Treasury yields in a speech last week: If yields are rising because of upward pressure on term premium, the Fed would regard that as tightening monetary conditions and become more dovish. On the other hand, if yields are rising because the market believes the economy is growing, the Fed will have to tighten further.

Financial conditions have tightened notably in recent months. But the reasons for the tightening matter. If long-term interest rates remain elevated because of higher term premiums, there may be less need to raise the fed funds rate. However, to the extent that strength in the economy is behind the increase in long-term interest rates, the FOMC may need to do more. So, I will be carefully evaluating both economic and financial developments to assess the extent of additional policy firming that may be appropriate to deliver on the FOMC’s mandate.    

Other Fed officials have spoken out and the tone has become more dovish. Boston Fed President Susan Collins believes in taking a more patient approach to monetary policy now that rates are at or near their peak, though further rate increases are still possible. Atlanta Fed President Raphael Bostic added to the dovish tone with remarks that the Fed may have done enough with its interest rate hikes to bring down inflation.

Fed Governor Michelle Bowman said interest rates may need to rise further and stay higher for longer than previously expected to get inflation down to target, which is a slight dovish pivot as her previous comments highlighted that multiple rate hikes may be needed.

Minutes of the FOMC September policy meeting, which was convened before the Treasury market yield surge, sounded a cautious tone:

All participants agreed that the Committee was in a position to proceed carefully  that policy decisions at every meeting would continue to be based on the totality of incoming information & its implications for the economic outlook as well as the balance of risks,

The September CPI report didn’t move the needle on monetary policy expectations. Core CPI was in line with market expectations and headline CPI was slightly above. Monthly annualized core CPI (blue bars) edged up, and so did the closely watched services ex-shelter CPI (red bars). I interpret this to mean that while the Fed may stay on hold, the possibility of one more rate hike is still on the table.
 

 

Putting it all together, the market doesn’t expect any further rate hikes and cuts to begin in mid-2024.
 

 

 

A durable rebound

In conclusion, the turnaround from the recent bond market tantrum was mainly attributable to excessive bearishness rather than to fundamental factors. Bearish sentiment was also evident in the equity market. S&P 500 breadth, as measured by the percentage of stocks above their 50 dma, fell below 10% in the most recent sell-off. While there are no guarantees, recent episodes of similar breadth wipeouts saw the stocks rally until this indicator reached at least 80%, indicating further upside in the coming weeks. Similarly, the 10-year Treasury yield should decline and find support at the 4.25–4.35% zone.