Will the Treasury Rally Turn to a Rout?
Jamie Dimon, chief executive officer of JPMorgan Chase & Co., said he’s concerned demand for Treasuries will decline and the Federal Reserve will raise interest rates faster than people expect.
The market won’t be able to rely on the biggest buyers of U.S. debt: the Fed, foreign nations and commercial banks, Dimon wrote in his annual letter to shareholders Wednesday. Increasing consumer and business confidence could boost demand for credit and reduce investor appetite for the haven of Treasuries, he said.
“These three buyers of U.S. Treasuries will not be there in the future,” Dimon wrote. “If this scenario were to happen with interest rates on 10-year Treasuries on the rise, the result is unlikely to be as smooth as we all might hope for.” JPMorgan is one of the 22 primary dealers that underwrite the U.S. debt and trade with the Fed.
The benchmark Treasury 10-year note yield fell six basis points, or 0.06 percentage point, to 1.70 percent as of 12:56 p.m. New York time, according to Bloomberg Bond Trader data. The 1.625 percent security due in February 2026 rose 17/32, or $5.31 per $1,000 face amount, to 99 11/32. Two-year note yields dropped three basis points to 0.70 percent.
Bear Case
Dimon’s bear case matches the consensus among economists surveyed by Bloomberg, who see yields rising through the course of 2016. The 10-year yield will climb to 1.92 percent by June 30 and 2.25 percent by Dec. 31, based on a Bloomberg survey of economists with the most recent forecasts given the heaviest weighting.
The Federal Open Market Committee reached a broad agreement to go slowly in raising U.S. interest rates due to increasing global risks, even as some policy makers indicated that an increase in the Fed funds rate target range at the April 26-27 meeting “might well be warranted” if economic data came in as expected, according to minutes of Fed’s March meeting published on Wednesday.
The minutes highlighted “that the positive momentum within the U.S. economy is being held back by developments abroad,” said Matthew Cairns, a strategist at Rabobank International in London. “Once the FOMC is satisfied these risks have abated, they will hike, sending Treasury yields back toward what we once considered ‘normal’ levels.”
Yield ForecastRemember Paul Singer's "bigger short" and the Maestro's dire warning on bonds? Now we have the CEO of the most powerful bank in the world telling us to get ready for a possible bond market rout as foreign demand for Treasuries dries up and the Fed might hike rates faster than the market expects.
Treasury two-year note yields, which are among the most sensitive to Fed policy, will climb to 1.40 percent in the next 12 months, according to Rabobank forecasts. That level hasn’t been seen since June 2009.
Treasuries returned 3.2 percent in the first three months of 2016, the biggest quarterly gain in almost four years, based on Bloomberg World Bond Indexes. The market rallied as a decline in stocks and oil sent investors to the safest securities.
Japan’s investors pared their holdings of foreign bonds at the fastest pace in almost 10 months as they adjusted positions before the start of the fiscal year. They sold a net 1.6 trillion yen ($14.8 billion) in overseas debt during the week ended April 1, the most since June, according to Ministry of Finance data released Thursday.
At this writing on Thursday, it doesn't seem like the bond market is worried about Jamie Dimon's dire warning (click on image):
As you can see, the yield on the 10-year U.S. Treasury bond keeps dropping and it might retest the 1.57% low it made on February 11th.
So if foreign buyers aren't snapping up U.S.bonds, who's buying them at these levels? Lisa Abromowicz of Bloomberg reports on hedge funds' crush on Treasuries:
Hedge funds are increasingly tying the fortunes of U.S. bonds to the rest of the world, which suggests that Treasury yields will stay low -- or go even lower -- in the near term.I think there's a lot of fear mongering when it comes to large hedge funds buying bonds. Moreover, I don't buy for a second that foreign central banks and sovereign wealth funds aren't going to be there to buy Treasuries. The new negative normal ensures they will and if there's another global crisis, they will all be scrambling to buy good old U.S. bonds (classic flight to safety).
These investors probably increased their Treasury holdings to record amounts over the past year, according to Federal Reserve data cited by reporters Liz Capo McCormick and Alexandra Scaggs in a Bloomberg News article on Monday. This is significant because these funds generally trade securities more frequently than sovereign wealth funds or central banks, which may make the debt more volatile day to day.
This isn't a completely surprising development: Hedge funds have more than doubled their assets under management since 2008 and now manage a record $2.9 trillion of assets, according to Hedge Fund Research. They need to find places to invest that money at a time of slowing growth and unfathomably low bond yields in Japan and Europe.
Hedge funds apparently saw a bargain in U.S. debt over the past year as commodity-dependent nations and China liquidated their holdings of the notes to support their markets and economies. In all likelihood, the funds mitigated the technical effects of such significant selling.
The shift does, however, underscore the degree to which the world's biggest debt market has been transformed in the past few years. Treasuries have gone from being basic staples for big buy-and-hold investors to opportunistic wagers for algorithms and relative-value traders.
And if you pit U.S. government bonds against other developed-market sovereign debt, Treasuries look great by comparison. Take a look at 10-year U.S. bonds: They yield 1.9 percent, almost 2 percentage points more than rates on similar-maturity Japanese debt and 1.7 percentage points more than similar German notes. Of course, bond buyers also must take into account currency fluctuations and the cost of hedges to eliminate this risk when thinking about relative value between these different types of debt. Sill, it's hard to see how U.S. Treasury yields can surge if hedge-fund investors are looking for bargains around the world.
About 70 percent of Japan's government bonds now carry negative yields, according to Bloomberg News reporters Kevin Buckland, Shigeki Nozawa and Yumi Ikeda. Even yields on some European corporate debt have fallen below zero as the region's central bank embarks on a plan to buy higher-rated company bonds.
There is a risk that greater ownership of Treasuries by hedge funds will make the U.S. bond market more volatile. These funds tend to use leverage to amplify returns, and a wrong-way bet can lead to more pronounced price jumps.
But there's also the possibility that the Fed data, which puts hedge funds under the rather all-encompassing and rather misleading category of "household and non-profit organizations," isn't totally reliable as a gauge of fast-money investments in Treasuries.
"Our sense is that the Treasury monthly flow data are not necessarily calibrated to pick up that direct, real-money investment from overseas," said Jim Vogel, an interest rate strategist at FTN Financial. In other words, the rapid increase in Treasury holdings being attributed to hedge funds may also include foreign investors racing to the U.S. to escape ever-lower bond yields in their home countries. As long as yields stay so incredibly low around the world, it's hard to see what would prompt these Treasury owners to sell in a wholesale fashion without other buyers stepping in.
That means while hedge funds could introduce more day-to-day unpredictability into in the Treasury market, over the long term they are unlikely to roil the low yields that are sweeping the globe.
As far as the Fed, it sent the signal that an April rate hike is unlikely, and with the Eurozone stuck in deflation, I doubt it will raise rates in 2016. More worrisome, the Fed's Labor Market Conditions Index is at its weakest level since 2009, diverging from the non-farm payrolls data (click on image):
With corporate profits declining for the first time since the Great Recession, it's hard to see U.S. job gains continue unabated in this environment and maybe that's the primary factor driving U.S. bond yields lower.
In fact, Albert Edwards, the notoriously bearish analyst at the French bank Societe Generale, released a note on Thursday highlighting that his "failsafe recession indicator" had stopped flashing amber and had turned to red:
"Newly released U.S. whole economy profits data show a gut wrenching slump. Whole economy profits never normally fall this deeply without a recession unfolding. And with the U.S. corporate sector up to its eyes in debt," he said in the note (click on image).Clearly the bond market isn't worried about the Fed or inflation. In my opinion, it's a lot more worried about the global deflation tsunami, another financial crisis and a full-blown profits recession. This is why I wouldn't be surprised to see the yield on the 10-year Treasury bond closer to 1% than 2% at the end of the year (those perennially bond bearish Wall Street economists will be proven wrong once again).
Corporate profits in the U.S. are key for Edwards as a driver of the economic cycle. He looks at U.S. whole economy profits before tax and focuses on domestic non-financial companies. He says these are currently leading the business investment cycle and, ultimately, the overall economy into recession.
"Whole economy profits data give a wider and cleaner estimate of the underlying profits environment than the heavily doctored pro-forma quoted company profits data," he said in the note.
Federal Reserve tightening may not be a necessary condition to catalyze a recession, according to Edwards, who believes that the deep profits downturn is sufficient in itself to push the U.S. economy overboard. He adds that the economy will "surely be swept away by a tidal wave of corporate default" and U.S. corporate debt should be avoided, even more so than the "ridiculously overvalued equity market."
Below, hours after his bank's earnings announcement, JPMorgan CEO Jamie Dimon caught up with Yahoo Finance's Andy Serwer to chat about the state of the industry, the economy, and the political environment.
Also, Gam Group Chief Economist Larry Hatheway and Western Asset Management Deputy CIO Michael Buchanan discuss JPMorgan CEO Jamie Dimon's warning that the Fed may move too fast. Hatheway and Buchanan speak on "Bloomberg ‹GO›."
And CNBC's Rick Santelli discusses bond prices and yields as well the dollar/yen trade. Just remember what I told you last Friday, as the USD weakens relative to other currencies, especially the yen, it loosens U.S. financial conditions but tightens them in countries trapped in deflation that rely a lot more on exports than the U.S. does.
If this trend continues, something will snap and U.S. bond yields will hit record lows.
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