The Vibe in Rates Has Changed. Know Yourself.

For the past few sessions we are seeing a new vibe creep into markets, driven by bonds.

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 US nominal yields have shot higher. Real yields have shot higher. Breakevens have shot higher. European bonds have shot higher. Yield curves have steepened. Unusually, the dollar has not rallied with US yields and precious metals have bounced from the pressure they were feeling last week. (Spreads between US and German yields have remained roughly unchanged).

Here is the yield on the German bund over the past one and 5 years. There’s a lot of scope for upside.

All of this is a very new, more inflationary vibe. Up until now, not only has the correlation between real yields and breakevens been negative (statistically very significant), but European bonds have tended to ignore increases in US yields. And any time US yields rose, the dollar reliably rallied.

The 5 year real yield and the 5 year breakeven are in the last two columns and rows, respectively.

It is tempting to say that this was catalyzed by the realization that the US tax package was going to pass, and do so against backdrop of synchronized global expansion with an infrastructure bill likely to be attempted in the New Year. And I think this is the right narrative—at least for now.

The question is how long will it last. Is it just another example of the markets belated overreaction to news that an efficient market would have discounted earlier, or is this something more real and the Phillip’s curve is finally being awakened from its slumber? After all, the US is moving along nicely in its economic cycle, president Trump seems determined to throw as much fuel on the US economy as possible, and Europe and Japan are likely to begin the normalization process 2018. And we know what an outsized role foreign flows have played in treasury yields.

I add to this that 2017 has been the first year since the GFC that taking the under on the Fed’s projected rate path was not the winning bet. This is important. The behavioral temptation for investors (and I very much include myself in this) who have been on the right side of that bet up until this year will be to dismiss it as an aberration, and assume ‘their world’ will reassert itself in 2018. As a general rule, the longer you hold on to your thesis, the harder it is to let go of it. And this is doubly true when your thesis has been working.

Personally, despite all this, I would still rather take the under with respect to the four projected US rate hikes in 2018, but my commitment to this thesis will now be heavily tempered by the recognition that this is the point in the cycle where I will be most vulnerable to confirmation bias.

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