The bond market is distorted

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Conventional wisdom sends “smart money” turning to the bond market to interpret investor expectations on things like economic growth or inflation. Sometimes these signals are strong and clear, but for most of this year the signals sent by Treasury yields appear to be broken.

Why is this important: The market still has things to tell us. But it has become increasingly difficult to decode these messages amid all the noise and complexity of the pandemic economy, says Drew Matus, chief market strategist at MetLife Investment Management.

  • For example, few investors are experts in COVID-19, supply chain bottlenecks and labor market disruptions, all in one, he notes.

More, Treasury yields have more and more were driven by technical factors that are separate from economic fundamentals, says Jim Caron, head of macroeconomic strategies for global fixed income at Morgan Stanley Investment Management.

  • On the one hand, the disproportionate presence of the Federal Reserve as a buyer of treasury bills, with a balance sheet that has soared to $ 8.5 trillion.
  • Short cover too. A short squeeze on Treasuries over the summer caught some hedge funds off guard and reinforced the upward movement in prices (and the corresponding drops in yields), as Bloomberg reported.
  • There is also the government’s use of the little understood general treasury account (TGA). It’s a bank account with the Fed that the Treasury pulled down to around $ 250 billion, up from $ 1.8 trillion at the start of the year – a levy that pumped even more money into financial markets. (read this Reuters explainer to learn more).

Inventory: In times of strong economic growth, Treasury yields typically rise as investors move away from safe-haven assets in search of better returns. But the benchmark 10-year Treasury yield fell by 50 basis points, or half a percentage point, between May and July.

  • And real returns, which explain the impact of inflation, have been strongly negative, a dynamic that in theory should not interest any investor.

And after: Some of those technical factors are receding, which has eased some of the downward pressure on yields over the past week, Caron says.

  • For example, the withdrawal of the TGA is largely complete. And the Fed last week became more explicit about starting to cut soon while potentially raising rates as early as next year.

It became clear this week, as well as concerns about the outlook for default if the debt ceiling is not raised – breaking down the distortions and pushing up yields.

The bottom line: “I think we should start to get clearer signals, but the Fed’s asset purchases will still be with us to some extent… so it’s still going to be a very heavily policy-influenced market,” Caron said.


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