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Macro Brief: 10-year Treasuries in trouble; How real is real?

Steen Jakobsen Steen Jakobsen
Chief Economist & CIO / Saxo Bank
Denmark

“All truths are easy to understand once they are discovered; the point is to discover them.”  Galileo Galilei 

The 60 basis point move in US yields during the last six months has so far had little impact on the risk-on versus risk-off market. Yes, AUD versus USD is small down and yes fixed income is having a negative year (outside: Club Med)….but how real is this move and why is it happening? 

We see a major change here which will be confirmed tonight if the 10-year US Treasury note yield again closes above 2.1000 percent. There is something changing in the 'perception' versus 'reality' trade. The easy part of not fighting the Federal Reserve is done – now comes the hard work!

US 10-year bonds

My great and educated colleagues Peter Garnry, Mads Koefoed and John Hardy provided me with some' ammunition' which could be of interest to you: the Mankiw model.

 Mankiw Federal Funds Rate Model

The Mankiw model looks at where the Fed should be for it to be in line with its dual mandate (maximum employment and stable prices). Looking at the chart above former Federal Reserve Chairman Alan Greenspan’s major policy mistake in 2003/2005 stands out. (The red line is lower to flat while inflation and the labour market took off.)

Now we are entering equilibrium – but as the great George Soros says: No market is ever in balance for more than a nano-second, and the present management at US Monetary Printing Inc. – sorry, the Fed is unlikely to react, like Greenspan did, before it is behind the curve. 

What is also interesting is that the forward curve is moving up – so not only are 10-year yields higher, the whole curve is higher including periods inside unchanged Federal Reserve policy. 

Add to this my post from yesterday about volatility being paid in 1 year and 2 year, then the 'truth' – whatever it is – is hard to ignore: something has changed! It may only be that the probability of printing money infinitely has become printing for decades but something is clearly happening. The belief in “unconventional measures is waning” – and fast it seems. 

All the research I see today talks about the move higher in yields being overdone - funny how it’s never the case the other way around! But I think Galilei was probably smarter than today’s pundits. (He did not need to update his Facebook profile so he had more time to actually think about things?)

EURUSD curve and USDJPY

Likewise yields on German Bunds and Spanish bonds are apparently breaking recent trends. Is this the price for retrospectively changing legal language, the impact of Tier-1 capital deleveraging or?

Spain 10-year generic

I think it’s all of the above. The banks are still underfinanced. Take away the Long-Term Refinancing Operation and European banks are in real trouble. The leverage has risen not decreased in 'Club Med' banks as they have bought more of the toxic government bonds which almost made them go under in the first place. But if you are CEO of a Club Med bank and sacked then nothing matters, so why not put everything on red? That's game-theory at its simplest and most convincing.

Conclusion
The early 'riding the wave' of easy money is over. The Federal Reserve will still try to engineer further easing, but the truth is harder to ignore and some time soon even the dogmatic Federal Open Market Committee will need to consider an attempt at an exit strategy. But isn't that the whole point of this 'new' open communication policy it has introduced with great fanfare?

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