Negative term premium holding back bond yields and US dollar
- Adverse positioning has halted the bond sell-off
- Economic and inflation data updates were neutral for rates
- Normalisation of term premium would see 10-year yield at 4%
- Traders will buy up US dollars if the bond market breaks through key resistance
By Max McKegg
Bond market traders have become frustrated with the post-GFC low rate environment and are champing at the bit, urging central banks to let go of the reins. But policymakers at the European Central Bank and Bank of Japan have made it clear they have no intention of doing so. In the US, the Federal Reserve has been less dogmatic; hence that’s where most of the front running has been done. Short positions in Treasury bonds are at record highs. FX traders are sitting on the sidelines, waiting to see how this game plays out. They’ll jump on board USD if the bond market can break through key resistance levels.
The chart below (click to large) shows the yield on the US 5-year bond going back to the last significant bear market in 1994. A valiant effort is being made to push towards the upper trend line.
But it’s hard going, especially when speculators are already heavily positioned for higher rates. Two steps forward, one step back.
T BOND shorts chart
The incoming economic data is not helping either. Wednesday's US retail sales came in under expectations and economists are lowering their expectations for first quarter GDP to around 2% on an annual basis. On the inflation front, the latest update on the Consumer Price Index showed some weak internals but headline numbers looked more promising.
Sluggish sales ... Recent US retail data came in below expectations, prompting economists to lower their expectations for Q1 GDP to around 2% in annual terms. Photo: Shutterstock
As shown in the chart below, the CPI is tracking along at 2.21% while the core rate is at 1.85%. That means core was only a touch away from being rounded up to 1.9% for the official one-decimal point release.
Furthermore, the big decline in mobile data plans this time last year is due to drop out of the annual calculation. This could add 0.2% to the core rate in next month’s CPI update. The headline rate might pull back a touch due to oil price effects but the bottom line is that both inflation readings should be sitting slightly above 2%.
Anticipation of the CPI reaching 2% is a major factor behind the build up of short positions in treasuries but enthusiasm should be tempered by the fact that the inflation benchmark the Federal Reserve uses – the price index of Personal Consumption Expenditures (PCE) – is running well behind the CPI at 1.5% on the core reading.
Dissecting the bond yield
Bond yields are a composite of two data points (i) the expected path for short term rates – known as the risk neutral yield and (ii) the term premium – the extra yield investors require to take on duration risk.
As the following chart shows, the risk neutral yield 10 years out is a bit over 3%. But the term premium is negative, leaving the 10-year bond trading around 2.80%. Historically the term premium averages over 100 basis points. Should the premium return to that level the bond yield would be closer to 4.00%
Term premium chart
Source: Capital Economics
The US term premium remains low because (i) investors see little chance of inflation breaking out to the upside and (ii) the “stock effect” of the Federal Reserve’s bond purchasing program.
Policymakers in the four major economies that have undertaken QE via asset purchases – the US, Eurozone, Japan and UK – all say that at some stage their buying reached a “crossover point” where accumulated holdings, having driven down the term premium through the acquisition stage, became dominant enough to subdue the premium without the need for further substantial purchases.
The ECB says less than 10% of German bunds remain free-float in the hands of private investors while the Bank of Japan, despite slowing up recently, has bought up 75% of the total government issuance this financial year and now owns more than 40% of the total government debt outstanding. In each case the stock effect is assessed to be dominant over flows which means, in theory, the central bank could stop buying altogether with little impact on the term premium.
In the US, a process of balance sheet normalisation has begun but is too slow to counteract the stock effect.
As for the other determinant of the bond yield – the expected path of short term rates – we will get some more information on that on Wednesday when the FOMC’s updated “dot plot” is released. In the December release the median forecast was for three rate hikes in 2018. As this chart shows (click to enlarge) the market isn’t quite there yet.
Fed funds chart
Source: Metastock. Create your own charts with SaxoTrader; click here to learn more.
The FOMC’s flight path for short rates will no doubt be the immediate focus of both FX and bond traders on Wednesday but in the bigger picture it be the projected end point that matters. This will show what the Fed sees as the natural or neutral rate of interest, the level at which it will be neither stimulatory or restrictive.
The market will take this into account to price the path of short rates over time. All traders will have to do then is make an educated guess as to when the term premium will move. That will have a far bigger impact on bond yields and consequently USD than incremental moves in the Fed funds rate.
– Edited by Robert Ryan
For more on forex, click here.
Max McKegg is managing director of Technical Research Limited. Follow Max here or post your comment below to engage with Saxo Bank's social trading platform.