The Jon Snow (King in the North in Game of Thrones) of fixed income markets has suggested that the end of the bull market is upon us. We only partially concur.
We agree that Treasury yields are still too low. Economic fundamentals are as benign as they have been for a number of years, and if anything are becoming more supportive. Accommodative monetary policy (the Fed funds rate remains well below the neutral rate, and for those that believe in the stock of purchases as the central banks seem to, the size of the Fed balance sheet is 20% of US GDP) along with stimulatory fiscal policy (an increasing and already large fiscal deficit) and ultra-loose financial conditions will ensure that, domestically, the US continues on its current path. Inflation remains an anomaly, but we are gaining confidence that the downside surprises are temporary.
Having said that, we believe that in order for Treasury yields to move meaningfully higher (say a move that takes the 10-year yield above 3%) we will need more than a break in the trend line of the 10-year yield chart. We require the fixed income anchor to be removed.
Over the last few years, Treasuries have greatly benefited from policies implemented by the European Central Bank (ECB) and the Bank of Japan (BoJ). Only when the BoJ moves away from its 10-year yield control target at 0% can global bond markets come back to fundamentals, can the term premium regain some value, and can 10-year Treasuries move into a new regime.
Until this happens, Treasury yields will increase – but will continue to look too ‘shiny’ in a relative-value world. After all, Treasuries are possibly the one asset in fixed income where investors get exposure to a fairly symmetric risk/reward outcome. Therefore, there is a place in a well-balanced portfolio for the ultimate safe-haven asset – at least until other core yields regain a degree of symmetry.
Last week the market got very excited about China diminishing or stopping the purchase of US Treasuries. It is certainly possible that it has been decided to reduce the allocation of reserves to the dollar in favour of other currencies. However, aside from political posturing, it is hard to imagine China selling Treasuries – it has too many of them, approximately $1.2 trillion. That would be equivalent to Daenerys Targaryen turning a flaming dragon against her own people. Something she would never do!