Gavekal Capital: US Treasury Bond Market is Confused

Monday, November 18, 2013

US Treasury Bond Market is Confused

Since making a trough in September around 99.50, January 2015 federal funds futures contracts, have bounced back above 99.80. At 99.50 in September, the futures market was discounting a 50bps fed funds rate in January 2015. Now, back at 99.80, the fed funds futures market is discounting unchanged overnight rates in January 2015. All of this is to say that expectations of when the Federal Reserve would tighten interest for the first time have shifted back, and now the market expects rates to unchanged through January 2015. The federal funds market has clearly responded to expectations of more monetary accomodation.

The US Treasury market is somewhat confused though. Expectations for more monetary accomodation should have the bond market in rally mode, taking rates lower. With tightening expectations having fully reversed the spring scare, and given the close relationship between 10 year bond rates and fed funds futures, long rates should be dropping (chart below).

In particular, TIPS rates should be dropping in response to expectations for more monetary accomodation. They could drop all the way back to -.6% to -.7% for the 10 year TIPS.

Inflation expectations embedded in the 10 year bond should be rising. With tightening in January 2015 off the table in the mind of the market, inflation expectations should drift back from 2.2% to 2.5%.

So, on balance, the removal of market expectations for monetary tightening in January 2015 should culminate in around a 1% drop in 10 year nominal bonds, with real rates (TIPS) falling 1.2-1.3% while inflation expectations increase 20-30bps.

Why is this not happening? One reason is uncertainty regarding the Bank of Japan's next move. In the abstract, if Japan decides to increase its monetary accomodation more than the Federal Reserve (by doing more QE on a dollar equivalent basis) then it totally neutralizes the Fed's move. This is the nature of currency wars. In the chart below, 10 year breakeven inflation is plotted alongside the Yen/USD exchange rate. If the Yen breaks breaks below 100 and holds, this should impart a negative bias to US inflation expectations....bringing on more pressure for the Fed to extend stimulative policies.

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