The Federal Reserve embarked on the current tightening cycle just over a year ago. The Fed Funds rat...
The Federal Reserve embarked on the current tightening cycle just over a year ago. The Fed Funds rate bottomed at 1% and has headed gradually higher in 0.25% steps to its present level of 3%. During the same period the yield on the 30-year 'long bond' has fallen steadily from around 5.3% to 4.3%.
When US interest rates started to rise from very low levels back in 1994, the outcome was very different. The first 2% rise in interest rates actually produced a 2% rise in 30-year bond yields. The question is, why have bonds behaved so much better in 2005 than in 1994?
As far as we can see, there are two main differences between now and then: sentiment and China. When interest rates bottomed in 1994, the consensus view on bonds was still pretty bullish. With cash rates through the floor, investors were aggressively buying bonds to shore up their income returns. By the end of the bull market, there were no buyers left and plenty of sellers and not surprisingly, therefore, bond prices plunged when interest rates finally bottomed.
This time around investors have been much more circumspect. Having got their fingers badly burned in 1994, they were not going to make the same mistake twice. Sentiment has remained stubbornly bearish and, ironically, this has meant that bonds have actually performed pretty well.
During the past decade China has emerged as a major player on the global scene. Indeed, by certain measures it is now the second biggest economy in the world. Thus far the emergence of China has been pretty good news for the US bond market.
First, competition from China has helped to cap inflation in the West. Second, demand from China has bid up the oil price which, in turn, has reduced consumers' discretionary spending and undermined confidence, without (thus far) having a big impact on inflation. Finally, China has directly supported bond prices through its foreign exchange policy of buying dollars (to maintain the renminbi peg) and parking them in the bond market. Will these factors continue to support bond prices going forward?
Our technical analysis suggests that the 30-year 'long bond' (currently hovering near multi-decade highs) is quite capable of further gains in the near term.
However, we would urge caution. First - without naming names - some of the most vocal bond bears are starting to throw in the towel. That is an ominous sign from a contrary perspective. Second, China is coming under increasing pressure to revalue its currency - a development that would be great for US exporters but disastrous for the US bond market. The current bond bull market is starting to look rather long in the tooth.
Emergence of China has been positive underpin for US Treasuries.
Danger signs emerging as bond bears start to turn bullish.
If China revalues currency it will be negative for US bonds.
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