US bonds are the new widowmaker trade

I have pointed out any number of Wall Street strategists that have been wrong about rising US yields this year as they await the inflation boogeyman. They all have their excuses:

  • Bonds were oversold and the recent bid is technical.
  • It’s Delta!
  • It’s Fed buying distorting the market.
  • It’s Japanese selling.

So on and so forth. The latest today is Morgan Stanley:

We think that it is important to avoid the trap of forcibly fitting a narrative to lower yields, a trap investors dealt with merely four months ago: Treasury yields rose sharply in March, largely due to selling from Japanese investors, based on their fiscal year-end considerations. Yet, most investors mistook the rise in yields as validation for a super-hot economy, and the consensus bought into the idea that 10-yeary fields were headed above 2%. We cautioned investors that yields had overshot relative to the economic reality. Over the coming weeks, economic data in the US couldn’t keep up with unrealistic expectations, and10-year yields started grinding lower. Despite thee lessons from March, July 2021 looks just like March in reverse. This time, investors are fitting a narrative of excessive pessimism to lowe yields. Many of these narratives don’t stand up to scrutiny. Let’s take the concern about the Delta variant. In the UK–a reasonable template for the US–hospitalizations remained low as cases spiked, the economy reopened anyway, and ultimately cases have started receding, suggesting overstated downside risks from COVID-19. Reassuringly, Fed Chair Powell concurred with this assessment at the July FOMC meeting. Another misleading narrative is that the market is pricing in a Fed policy mistake. But this doesn’t match up with record-low real yields and very high inflation breakevens, or even strength in risk markets. Some cite a decline in the economy’s long-term equilibrium rate–the r*–to fit the price action, oddly at a time when both growth and inflation are running at multi-decade highs. With a lack of a credible narrative to explain the large decline in yields, and the demonstrable role of positioning, we see a good case for higher yields from here.

Pardon me while I suppress a giggle. Bravo for seeking to not force-fit a narrative to falling yields but right back at ya! Japanese investors do not sell their bonds just because. They do so because they see something happening that suggests that they should. Like a massive US inflation spike which they correctly read as in the offing.

Whether these Japanese investors did so on the basis of fundamentals or reflexivity is an interesting question but they got it right, either way.

Moreover, there is a narrative that fits with falling US yields and it is that Chinese tightening is leading the US inflationary cycle, as it has done for three mini-cycles in a row, each time peaking shortly before US yields:

Why? Because China the literal production base of so many US goods, and the marginal price-setter in all commodities. It is US and global inflation/deflation engine.

This is even more exaggerated by the COVID-cycle which China led in and out, via the shock, the stimulus and now the tightening.

The Fed is making a policy error if it tapers. Not because the US economy can’t handle it. Because China, EMs and commodities can’t handle a higher DXY to go along with weakening Chinese demand and a falling CNY.

If the US tightens into Chinese tightening then the entire global reflation will go bust and Treasury yields collapse much further yet. We saw it in 2015, 2019 and it’s happening again.

Either or probably both of the Fed and PBoC need to back right off or this reflation is a bust.

That is the message that falling Treasury yields are sending.

Houses and Holes
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