Global Daily – The narrative behind the Treasury market sell-off

by: Nick Kounis , Arjen van Dijkhuizen , Bill Diviney , Kim Liu

The US Treasury market has sold off over recent days, dragging other government bond markets with it. US 10y Treasury yields – at 2.59% – are up by 12bp since the start of the year and 23bp since the start of December. The narrative behind this sell-off is extremely rich, with a number of events helping to fuel rising government bond yields. In today’s daily, we set out the drivers and assess the outlook for US Treasury yields.

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China’s negative view – The latest trigger for higher yields was leaks suggesting that the Chinese authorities are taking a more negative view on US Treasury securities. Bloomberg News reported that ‘senior government officials in Beijing reviewing the nation’s foreign-exchange holdings have recommended slowing or halting purchases of U.S. Treasuries, according to people familiar with the matter’. The news story seemed to have a disproportionate impact because bond investors were already jittery. China is indeed the world’s biggest investor in US Treasuries, however their holdings should not be seen only in terms of an asset allocation decision in our view, but rather as part of their policy to manage movements in the yuan. Indeed, there is strong relationship between China’s FX reserves and their holdings of US Treasuries. Although in theory China would have some degrees of freedom to alter the composition of its FX reserves even under its current policy of a managed ‘peg’ versus a currency basket, it would shoot itself in the foot if these moves would go hand in hand with a sharp rise in yields / weaker dollar. That could lead to high valuation losses on China’s FX reserves held in USD, while a further CNY appreciation versus USD would impact China’s external competitiveness.

In our view, the commentary most likely has a political element and the comments might be a warning shot to the US administration against the background of trade tensions. Finally, given China’s Treasury holdings are most likely in short maturities, today’s steepening of the US Treasury curve after the China news broke out does not seem to make sense.

The BoJ taper – Earlier in the week, the idea that BoJ was tapering its JGP purchases also hurt the Treasury market. The BoJ reduced its purchases of long term government bonds on Tuesday (10-25 year and more than 25-year), adding to speculation that this might be the first step towards the exit for the BoJ’s QE programme. This soured bond market sentiment globally. We think financial markets may be over-stating the significance of this move. The BoJ has a yield target not a quantity target and therefore its purchases of JGBs reflect what it thinks it needs to do to maintain its yield target. Is a change in its yield target imminent? We doubt it. Although economic growth is strong, modest inflationary pressure has only just started to materialize, with CPI inflation ex-food and energy at just 0.3% yoy in November. It seems too early for the BoJ to remove policy accommodation.

Global central bank exit – A broader theme that has driven Treasury yields higher over the last few weeks has been the view that central banks are scaling back their super-accommodative monetary policies. Of course the Fed has been at the forefront of this trend, with a 25bp policy rate hike in December, with a forecast of three more steps to come this year. Meanwhile, some ECB officials have recently suggested that the 2018 extension might be the last. Still with underlying inflationary pressures being subdued, our sense is still that the road to the exit will be a relatively long one. We expect the Fed to hike twice this year. We do not expect the ECB to extend QE again, but the taper period could take asset purchases into early 2019, while rate hikes will unlikely follow until the second half of the year.

Outlook for US Treasury yields – The 10y US Treasury yield is now close to our year-end target of 2.6%. Over the last few Fed rate hike cycles, the peak for US 10y Treasury yields has been around the eventual peak of the Fed’s policy rate. We think the short-term interest rates will peak at around 2.5%, while the Fed’s view of the neutral rate is 2.75% (and has been coming down). So the peak in US Treasury yields may not be that far off if we are right about where short rates will ultimately end up.  Another factor supporting that view is our sense that US core inflation will likely remain moderate, as accelerating US productivity growth offsets the inflationary impact of wage gains. Meanwhile, China’s contribution to global inflationary pressures seems to be easing (please see below).

China Macro: Industrial tailwind ebbs as producer price inflation drops – This morning, China’s inflation data for December were published. Consumer price inflation (CPI) edged up a bit, to 1.8% yoy (November: 1.7% yoy), driven by an easing of food price deflation. With food prices bouncing back further, we expect CPI to rise towards 2.5% this year, remaining below the PBoC target of around 3%. Core inflation remained subdued as well, falling back a bit to 2.2% yoy in December (November: 2.3% yoy). The most eye-catching movement on the inflation front was the sharp drop in producer price inflation (PPI), by almost a full percentage point, to 4.9% yoy (November: 5.8% yoy). This drop was anticipated by markets and largely reflected the fading of base effects. Having been negative between March 2012 and August 2016, PPI started to rise sharply in late 2016, with the sharpest rise in annual terms in November/December 2016. This rise had been driven by a rebound in commodity prices as well as production cuts in oversupply sectors such as steel and coal. All this also boosted profitability in China’s industrial sectors last year. Going forward, we expect producer price inflation to ease further in the course of this year, causing this tailwind for the industrial sector to ebb and China’s contribution to global reflation to fade somewhat. For more background, see our China outlook for 2018 here.