The Death of the US Treasury Bond Vigilante

Earlier today, Bloomberg reported that the yield on a 10-year US Treasury bond fell below 1.50% for the first time in months. And this happened literally the day before a consumer price inflation number expected to come in at 4.7%. That means the US ten-year yield is deeply negative in real terms. The question is why. And what does this mean for bond investors?

“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But know I would like to come back as the bond market. You can intimidate everyone.”

-James Carville, Advisor to President Clinton, 1993

Oh how times have changed. The bond markets aren’t intimidating anyone right now. It’s the Fed doing all the intimidation at the moment. Here’s why. And forgive me if you’ve heard this speech before.

The Federal Reserve is the monopoly supplier of reserves. And so, the smart money in markets understands that the Fed, as a monopolist, will always be able to hit its federal funds target. And so, if we think of long-term interest rates as a series of future short-term interest rates smashed together, it becomes clear that long rates are heavily influenced about market expectations for future policy.

So, think of the bond vigilantes less as vigilantes intimidating in the Carville way and more as prognosticators frontrunning future policy decisions. Let’s call them Bond Frontrunners.

What the Bond Frontrunners are telling you is this:

1. The Bond Frontrunners believe the Fed now when the Fed says it will keep rates at zero even though real yields are deeply negative. That doesn’t mean they won’t change their mind. For now though, they have acquiesced.
2. Just maybe some frontrunners are starting to actually believe inflation is transitory. We’re at the period of maximum uncertainty on the transitory inflation score. So, beliefs on this are completely speculative. Even so, they won’t actually matter unless the Fed’s reaction function is inflation-dependent.
3. Bond Frontrunners are starting to think the Fed’s reaction-function may not be as inflation-dependent anymore. Unemployment is front and centre. And that’s reason to accept lower yields.
4. Whether inflation is transitory or not is irrelevant. As long as the Fed is the monopoly supplier of reserves, it can suppress yields to its heart’s content. And there’s nothing we can do about it.

You put all of this together and it speaks to another potential widowmaker trade in the making, where the so-called vigilantes had a go at the Bank of Japan over and over again. And the BoJ beat them back decade after decade even as the government debt to GDP soared well over 200%. This speaks to the monopoly power of the central bank.

I don’t think it’s any different with the Federal Reserve even if the US has a current account deficit. All it means is that the currency will be the release valve.

So how do we trade this?

1. Watch the employment and jobless claims prints. That’s where Fed policy is geared. That’s what moves the needle on rates
2. Inflation is now in the free pass period. Let’s see how the market reacts tomorrow to validate that statement
3. Bad news on the employment front is good news for risk assets because it keeps the Fed on hold. Really, really good news is bad news, especially for high beta shares that are duration-sensitive due to their DCF.
4. The pain trade is yields lower i.e. where the short Treasury position isn’t. And that also happens to be where convexity forces duration-matching investors to buy, resulting in a potential big move down in yields as shorts cover.