The Case For Lower Treasury Bond Yields?

Maggie Fitzerald and Hannah Miao of CNBC report the Dow jumps 440 points to record, rebounding from one-day slide:

All three major averages notched record closes on Friday, rebounding from the previous session’s losses over concerns of a slowdown in global economic growth.

The Dow Jones Industrial Average rose 448.23 points, or 1.3%, to a record close of 34,870.16. The S&P 500 bounced by about 1.1%, closing at an all-time high of 4,369.55. The technology-heavy Nasdaq Composite rose just shy of 1% to close at a record of 14,701.92.

The S&P 500 earned its sixth week of gains in seven.

Friday’s comeback brought all three majors averages into the green for the week. The Dow rose 0.2% for the week. The S&P 500 and Nasdaq gained 0.4% and 0.4% since Monday, respectively.

The stocks that led the losses on Thursday, reopening plays and banks, notched gains on Friday. Bank of America jumped about 3.3%, leading a bounce in financial shares. Royal Caribbean popped 3.6% and Wynn Resorts gained close to 2%. American Airlines and United Airlines both gained more than 2%.

The small cap benchmark Russell 2000 rallied more than 2% on Friday.

Shares of General Motors gained 4.8% after Wedbush said the stock is a buy and could jump more than 50% as investors realize the extent of its tech and electric vehicle evolution.

Big Tech stocks’ gains were capped on Friday as President Joe Biden signed a new executive order aimed at the competitive practices by the sector’s giants. Amazon fell 0.3% after hitting a new all-time high on Thursday.

The yield on the 10-year Treasury rebounded 7 basis points to 1.36%, easing concerns about an economic slowdown (1 basis point is 0.01%). Falling yields have mystified investors lately, with the 10-year yield falling to 1.25% at its low on Thursday.

Thursday’s losses, which saw the Dow drop nearly 260 points, came as the proliferation of the highly infectious delta Covid variant also fueled worries about the global economic comeback. The Olympics announced a ban of spectators at Tokyo’s summer games as Japan declared a state of emergency to curb the spread of coronavirus.

“Our central case has been for a choppy July” with the S&P 500 falling as low as 4,100, wrote Tom Lee, Fundstrat’s head of research, in a note to clients Thursday night. “While this is a possibility, we think there is a chance [Thursday] marked the peak of [the] ‘growth scare’ and if this is correct, equities might be shifting toward a broader risk on.”

Further, the latest jobless claims report released Thursday indicated a potential slowdown in the labor sector.

“The market is solidly mid-cycle and with that typically comes a 10-15% index level correction. We expect such a correction will create buying opportunities given a still strong growth backdrop,” Mike Wilson, Morgan Stanley’s chief U.S. equity strategist, told clients. Wilson favors financials, healthcare and materials.

Martin Crutsinger of the Associated Press also reports the Federal Reserve pledges 'powerful support' for economy: 

The Federal Reserve says its low interest rate policies are providing “powerful support” for the economy as it recovers from the coronavirus pandemic.

In its twice-a-year report to Congress on monetary policy released Friday, the Fed indicated that it planned to maintain that support until further progress is made in recovering from last year's severe recession.

Over the first half of this year progress on vaccinations helped to re-open the economy and produced strong economic growth, according to the Fed, but it said the lingering effects of the pandemic continue to weigh on the economy, with employment still well below pre-pandemic levels.

The Fed has kept its benchmark interest rate near zero while continuing to buy $120 billion a month in Treasury bonds and mortgage-backed securities to put downward pressure on long-term interest rates. It said Friday that these efforts will help ensure that “monetary policy continues to deliver powerful support to the economy until the recovery is complete.”

The new report will be the subject of two days of hearings next week. Fed Chairman Jerome Powell will testify Wednesday before the House Financial Services Committee, and Thursday before the Senate Banking Committee.

Lawmakers will seek details on exactly when the central bank will start cutting back on its bond purchases, and when it will begin raising interest rates.

The report Friday repeated wording used by the central bank since last year, explaining that it does not expect to begin raising interest rates until its goals on maximum employment and inflation have been reached.

It also reiterated the Fed's expectation that monthly bond purchases will remain at the level of $120 billion “until substantial further progress has been made” toward its employment and inflation goals.

Shortages of materials and difficulties in hiring have had held back activity in a number of industries and bottlenecks so far this year and other transitory factors have boosted inflation, according to the report.

“Consumer price inflation has increased notably this spring as a surge in demand has run up again production bottlenecks and hiring difficulties," the report read.

But the report repeated the view of Powell and other Fed officials that any spike in inflation is likely to be temporary.

“As these extraordinary circumstances pass, supply and demand should move closer to balance, and inflation is widely expected to move down,” the report stated.

Minutes of the discussions at the Fed's last meeting in June showed that central bank began consideration of when and how they will start reducing the bond purchases but that no conclusions were reached. Most private economists don't expect the actual bond tapering to begin until late this year or perhaps not until early in 2022.

It was another interesting week in markets but despite the fireworks on Friday, it wasn't a good week for cyclical shares:

The main reason is that bond yields fell precipitously this week as concerns over the delta variant spreading in the US and throughout the world pick up.

Interestingly, looking at the 6-month chart of the 10-year US Treasury bond yield, you see that after peaking at 1.7650% back in March, the 10-year yield now stands at 1.3560% which is quite a drop:

You're still well above the 1% hit in late January and the 0.5% 52-week low but that's a huge drop in long bond yields.

The recent drop in long bond yields has bolstered growth stocks (VUG) over value shares (VTV) as investors brace for a slowdown in the global economy:

 

 

The key question now is whether yields will continue to drop or have we seen the worst of the backup in yields for now?

Chen Zhao, Alpine Macro’s Chief Global Strategist, wrote an excellent report this week making the case for lower Treasury bond yields. 

 

The gist of the report is this: 

The world has been on the inflation bandwagon, with many strategists and prominent investors calling for a major inflation outbreak. Our report, however, looks at the opposite case. The report explains why inflation could fall much faster than many anticipate and lays out the reasons why U.S. 10 Year Treasury yields could head significantly lower. 

I urge my readers to contact Alpine Macro directly to read the complimentary report, but I will share a few tidbits from it: 

• "Our basic projection for 10-year bond yields is flat to down. There is better than 50% probability that 10-year yields will fall towards 1.2% by year end, or even lower, especially if a “perfect storm” hits the world financial markets."
• Jerome Powell has a track record of being a flip-flopper and this has often caused undue market fluctuations, driving the yield curve, for example, to the brink of inversion in August 2019. With the FOMC raising its 2021 inflation projection to 3.45% from 2.4%, the bond market is concerned the Fed may get progressively more hawkish just when inflation is peaking. 
• [...] U.S. bond market does not operate in isolation and is always strongly influenced by global conditions. At present, Japan is back to deflation, and both China and eurozone inflation are running at barely 1%. Suffice it to say, inflation is extremely subdued outside the U.S., even though commodity prices have surged. Although German bund yields have risen sharply, they remain below zero. JGB yields have fallen along with U.S. Treasury yields in recent months and are flirting with zero (Chart 5). These extremely low bond yields are reflective of excess savings around the world, which will continue to play a role in keeping Treasury bond yield increases at bay.
• With bond yields more likely to fall than rise, equity allocation should tilt towards owning more growth stocks, FAANGM in particular.

In terms of bonds or stocks, I note this chart below showing the levels of the equity-bond ratio from a secular perspective. It is at a three-sigma overshoot, which suggests that the forces of “mean reversion” may support bonds more than equities:

It remains to be seen whether stocks get hit and bonds rally more in the second half of the year but for now, the "Fed put" is still supporting risk-taking behavior. 

When I look at the 5-year weekly chart of TLT 20+ Year Treasury Bond ETF, it tells me to remain long here as prices will likely continue to rise (yields will continue to decline):

One thing is for sure, however, markets are choppy, speculative activity in meme stocks is waning, there are renewed fears about the delta variant and people are positioning themselves more defensively, buying more large cap old tech (Apple, Amazon had a great week).

Of course, inflationistas remain resolute and undeterred and some are warning investors not to buy the rally in Treasuries.

Below, Jeff Sherman, Doubleline Capital deputy chief investment officer, joins 'Closing Bell' to discuss his outlook for the 10-year Treasury yield, what the Fed policy could look like in the year to come and why he says investors need to reduce their exposure to certain areas.

And CNBC's "Halftime Report" team discusses markets, interest rates, stock picks and more with Tom Lee of Fundstrat. Great discussion, have a great weekend everyone!