Bond investors are now contemplating what it would take the Treasury market’s benchmark yield to 2%, a level not seen since the days following Donald Trump’s presidential election victory in 2016.
Besides the usual bugaboos of an economic downturn and a global trade war, Ed Al-Hussainy of Columbia Threadneedle said just the way market participants are set up in the bond-market may be enough to provide the impetus for the 10-year Treasury yield to breach the key psychological level.
“One of the catalysts that can move yields lower is the short-space capitulating,” Al-Hussainy, senior interest rates and currencies analyst for Columbia Threadneedle, told MarketWatch.
The 10-year Treasury yield TMUBMUSD10Y, -2.12% is trading at 2.159%, near its lowest since Sep. 2017, down more than 1 percentage point since the benchmark rate hit multiyear highs in November, Tradeweb data show. Shorter-dated maturities, sensitive to expectations for monetary policy, like the 2-year note yield TMUBMUSD02Y, -3.52% and the 5-year note TMUBMUSD05Y, -2.94% have already pushed below 2% on Friday. Yields and bond prices move in opposite directions.
Yields continued their fall Friday after Trump’s threat to place tariffs on Mexican imports drove demand for assets, like government bonds, that are considered safe.
Al-Hussainy points out data from the Commodity Futures Trading Commission shows hedge funds and other speculators have increased their short positions — bets that Treasury prices will fall and yields will rise — since January in 10-year Treasury futures. The amount of bullish bets exceeding bearish ones among speculators stood at 423,351 contracts as of May 21, the biggest net short positioning in 10-year notes in around six months.
Outsize positions held by speculators are often viewed as potentially contrarian signals. In the case of a short squeeze, weak-handed speculators could be forced to buy back futures, accelerating a rally and driving down yields.
On the flip side, money managers have added to their bullish positions, with many drawn to the bond-market’s haven qualities amid geopolitical tensions from Brexit and trade concerns. The J.P. Morgan survey showed institutional investors who held more longer-dated Treasurys than their portfolio benchmarks rose to 37% on Tuesday, the highest level since Nov. 2010.
If a further decline in yields forces the speculators to close their bearish bets, or “covering” their short positions, this short squeeze could supercharge the bond-market’s rally, pushing it over the 2% hurdle, Al-Hussainy said.
There’s ample history to demonstrate how a sudden shift in investor positioning can push yields to levels beyond what analysts think economic fundamentals warrant. Al-Hussainy said the sharp decline in Treasury yields at the end of 2018 did not reflect the deterioration of U.S. growth, which had yet to soften, but rather short-covering activity by bond-market speculators.
“If you think about the velocity of the move in December, investors were very long risk, and very short Treasurys. That equation flipped very quickly and it accelerated the [Treasury yield’s] move to the downside,” he said.
A slump to 2% would arouse fears that the U.S. was on the brink of a recession, seen as an unlikely scenario among investors who point to the Federal Reserve’s patient stance, tight labor markets and strong growth in the first-quarter of 2019.
But the recent outbreak of trade tensions has weighed on the optimism of investors who depended on a swift resolution to U.S.-China’s trade dispute to alleviate fears around the global economy’s health.
Since Trump announced higher tariffs on Chinese imports on May, equities have come under pressure and bonds have rallied. The Nasdaq Composite COMP, -1.46% is off 7.3% from its all-time closing high on May 3, while the S&P 500 SPX, -1.28% is down 5.3% from its record closing high on April 30, Dow Jones Market Data shows.