Back on May 18 [see: Bonds and Value] I suggested the 10Y might be a good value at 118’105 (yield of 3.11%.) The 2s10s had just reached a trend line connecting previous lows.
And, 10Y price had just reached the bottom of a rising channel.
It was an important test, as we discussed at the time.
The 10-year is at an important inflection point, poised between a strong rebound and a significant selloff. Its next moves are critical not only from an investment standpoint, but in terms of what to expect from the broader economy.
Now that yields have broken out and prices and spreads have broken down, we’re already beginning to see the effects on the market and the broader economy. Bottom line, they aren’t good.
The Fed is bent on (1) creating more headroom for easing the next time it’s needed, and (2) dealing with an inflation problem that the official data don’t reveal but which is very real and getting worse. They are also wary of allowing a 2s10s inversion because it would portend a recession. Last, they are trying to prop up the USD because it helps stave off inflation that would pressure rates higher.
They can’t very well come out and say inflation is really pushing 6 or 10% without panicking the bond markets. So, they’re talking yields up slowly and, more importantly, not pressuring them lower as has been the case for the past decade.
The repercussions, though, are already being felt domestically in the overinflated housing market, in the auto market, basically anything which relies on low interest rates for sales. But, the most serious repercussions are in emerging markets, where huge amounts of dollar-based debt must be repaid with appreciating dollars. The defaults could be catastrophic.
The critical question is how high rates might eventually go. Here, the view is hopeful. Members might recall we had two potential channels for ZN, the price of 10Y notes. I never liked the white channel that much because the midline was all wrong. The yellow channel worked perfectly except for the slight overshoot in 2012 – which was a year of heavy, heavy manipulation.
So, I’ve always been inclined to believe more in the yellow channel — which says that 10Y yields have now topped and ZN has bottomed.
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