Since last week’s stronger than expected June non-farm payrolls, which coincided with the lowest unemployment reading (6.1%) since Sept 2008, bonds have, in a fairly counter-intuitive manner, rallied. Measured by the iShares 20 yr Treasury etf (TLT), Treasuries are up more than 2.5% in a week:
For an equity / options trader like me, this price action is all a bit confusing. I was of the mindset that improving U.S. data should cause investors to look for riskier assets that should benefit from an economy poised to perform in a less contrived interest rate environment. And it wasn’t just the recent data – the minutes of the FOMC’s June meeting indicated the Fed would be done with their QE bond buying program in October, thus relieving the market of what was once a buyer of $85 billion of bonds a month. And again, bonds rallied. We put out a short the other day in TLT (read here) and I am already worried about it. Speaking to some fairly smart people in the market place on the bearish bond view, the response I get is not too dissimilar than that of the view at the beginning of the year – POSITIONING.
Looking back at the fairly epic moves in Treasuries over the last 2 years, the prevailing wisdom, despite what many pundits described as a bond bubble, was not to Fight the FED. As long as QE was in place, Bonds would continue to rally. In Mid 2012, calling a bond bubble became a bubble, and interestingly that the was the top (circled red below). And then in mid 2013 (circled below in yellow) we had the now infamous “Taper Tantrum” where the Fed hinted to how and possibly when they would start reducing bond purchases, and that was the nail in the coffin for the QE gravy train, at least as it relates to blindly owning treasuries.
At the end of last year, after what amounted to one of the most rapid interest rate moves (from May to the end of Dec the yield on the 10 year Treasury went from 1.6% to ~3%), the trade turned on a dime (circled above in green). So again it was a one way train, but this time with Treasuries moving higher. Conventional wisdom was that the Taper was on, and the FOMC would likely be forced to raise rates sooner than the market expected and BAM, we got a very counter-intuitive move higher. Again, this is all a bit above my pay-grade, but the chart above points to what looks like a fairly obvious inflection point, especially as we get closer to the preliminary Q2 GDP report expected July 30th.
Now, it’s near impossible to find out why a market as large as Treasuries is moving one way or the other. But there are several theories on why the bond market is rallying as QE winds down. First, some view the risks to stocks as moving higher as QE winds down, which could lead to some shift into Treasuries as investors move away from risk assets. Second, some traders think that a more hawkish Fed could threaten future growth, which is a reason to buy Treasuries. Third, some traders likely just have low expectations for future growth given the poor Q1 GDP print and bad consumer spending numbers. Of course, those selling Treasuries have equally divergent views, or perhaps another reason for selling altogether.
I would add one more point. This week, global equity markets got a little dose of volatility as sovereign yields rose in Portugal, and what did investors do, they bought U.S. Treasuries. So for those who share my view that logically bonds should go down IF the Fed is right, it is important to note that U.S. Treasuries remain the Safe Haven asset of last resort for global investors and if we are about to see a confluence of Geo-Political risks spark up, then it really won’t matter how much or little the Fed is buying, bonds will rally.
So with our current TLT trade, we’re essentially playing for an inflection point pull back. But that could be proven wrong very quickly if we see a pop above recent highs. So we’re going to keep this one on a tight leash, with a stop if it get’s above $114. If we see the reversal we’re playing for we’ll be much more patient.