What's behind the rapid rise in rates?
For context, “rising rates” has only been an issue for the last seven business days, as the 10-year Treasury yield has risen more than 40 basis points since just Sept. 4. To assess what is going on, we first must note how August was a startling rally in bond prices, with the yield on the Bloomberg Barclays U.S. Treasury Index (which includes all notes and bonds, market-value weighted) plummeting 43 basis points, placing that monthly change in the largest 94th percentile of absolute monthly changes in the index yield in the last 20 years. Why?
- The back-and-forth escalation in the U.S.-China trade war during August—including new tariffs from both sides, a cessation of U.S. agricultural purchases by certain Chinese entities and China devaluing its currency—served as the key driver of sharply lower global bond yields.
- The Fed eased at the end of July to counter/cushion the evident U.S. and global growth deceleration, opening prospects for more easing to come.
- At the same time, economic data continued to erode out of Germany, which is on the front lines of the global trade contraction; risks of a no-deal Brexit rose; and violent clashes in Hong Kong brought forth the fear of a Tiananmen Square-like violent crackdown by the Chinese government, which if it were to come to pass, almost certainly would derail any potential trade deal.
In short, a perfect storm of bond friendly economic and geopolitical developments hit at the end of summer, which typically is a thin market and, as such, can experience volatile moves.
Fast forward to September and many of the hot August concerns have cooled, driving the subsequent massive reversal in yield direction. For example:
- U.S.-China trade tensions have eased on meaningful gestures from both sides—the Trump administration delayed the start date of certain tariffs and China is now encouraging its companies to buy U.S. agricultural products—and a new round of negotiation has been scheduled for early October.
- China has signaled a willingness to manage through, rather than crush, the Hong Kong protests.
- The U.K. Parliament took steps to prevent a no-deal Brexit that Prime Minister Boris Johnson had seemed committed to producing on Oct. 31, pushing any such outcome further into the future and opening the prospect for an election in which other Brexit outcomes may emerge.
- Better-than-expected ISM services data, rising core CPI and buoyant U.S. retail sales are among macro data serving to counter fears of a U.S. recession and an imminent race to zero yields.
- This same U.S. data has prompted a meaningful paring of the expectations for further Fed easing at the next few meetings, decreasing the prospects for a 50 basis-point cut next week and revising higher the potential that the Fed will only ease a total of 3-4 times in a mid-cycle adjustment rather than ease to zero to fight a U.S. recession.
- The European Central Bank (ECB) introduced a variety of new easing measures this week to counter the slowdown across the Continent and the accompanying low-inflation environment. Its moves, including a further reduction in its already negative benchmark rate and a new round of quantitative easing with no set end date, should keep high quality sovereign bond yields negative in much of Europe. But such moves seem to be confronting diminishing returns, with questionable prospects for supporting European growth and inflation. Perhaps more importantly, the ECB’s actions seem intended to encourage fiscal easing in Germany, a tall order for the notoriously tight-fisted German government.
Fortunately, we have been pretty cautious with the duration lever lately, staying mostly neutral since April with only small tactical deviations as trying to position duration for the massive shifts in events surrounding the global slowdown and the ever-evolving U.S.-China trade conflict is obviously difficult. At generally neutral, we have been able to ride the wave to lower yields, allowing Federated bond funds to participate fully in the rising bond price environment that has persisted for many months, until September. Of course, being selectively long or short would have added a bit more value, but that is abundantly clearer in the rear-view mirror. Large market moves also have elevated the risk of aggressive positioning in either direction.
The U.S.-China conflict, the Fed’s extent of easing and whether the U.S. economy finds a soft landing amid the current global deceleration hold the keys for yield direction as we head into the end of this year and into 2020. The approximately $14 trillion of negative yielding high quality sovereign debt abroad will continue to provide a downward gravitational pull on U.S. yields but will not prevent meaningful variation within a generally low-yield range. Thus, we remain focused on potential modest tactical duration adjustments, which could include attempts to capitalize on the emergence of a new yield range, until events unfold sufficiently where we can develop a more confident strategic view on the direction of rates longer term.