If Yields Can’t Breach 3.0%, What Then?

For the second time in three months, 10Y yields reached just shy of critical level of 3.0%, or 2.996% to be precise, the highest level since 2014, before once again fading most of the move. So with the 3.00% on the cusp of breaching one of two critical trendlines, one bullish and one bearish…

If Yields Can't Breach 3.0%, What Then?

… the question is what happens next: will it blow out above 3.00%, rising to 3.05% first – the highest intraday level since 2011, hit on January 2, 2014 and also the long term double bottom neckline and the long term channel top – and then blast off on the way to 4% or more, or, again unable to breach 3.0%, will the 10Y slump?

One person who expects the 10Y to only accelerate in its selloff if, and when, it blows through 3.00%, is DoubleLine’s Jeff Gundlach, who last month and again today at the Ira Sohn conference, said he expects the S&P 500 Index to fall this year if yields on 10-year U.S. Treasury bonds move above 3 percent. Gundlach has warned that 10Y yields are likely to climb as deficits increase and the Federal Reserve reduces its balance sheet.

However, judging by today’s market action, it may probe problematic for 10Y yields to breach above 3.00% as a lot of buying interest appears to be lined up just below the key barrier.

So until we get more clarity in either direction, the following prediction from Morgan Stanley’s head of Rates Strategy Matthew Hornbach appears to be the safest of all, to wit:

With 10y Treasury yields above the 2.95% YTD high, the market is setting up for a break above 3.00%. A break above 3.00% suggests 3.25%, while failure suggests a retest of 2.70%. We turn tactically neutral on the US Treasury curve and duration as risk-reward looks poor.

So… 3.00% is the catalyst for the next major 10Y selloff, but 2.996% isn’t?

If Yields Can't Breach 3.0%, What Then?

Hornbach explained his logic in a Bloomberg TV interview today.

“A lot of investors that we speak with, when I ask them ‘Where would you want to enter the market and start to buy Treasuries?’ you’re typically hearing numbers like 3 percent on the 10-year, 3.25 percent on the 30-year,” Hornbach said, adding that just because those are such “common numbers,” they can drive momentum up or down.

As Bloomberg adds, and as shown in the top chart, debt investors have been focused on the 3% level to gauge whether the three-decade bull market in bonds is at an end, and to assess how much a glut of supply from the U.S. Treasury will weigh on investors.

As noted above, once above 3.0%, the next level is 3.05%, the January 2014 intraday high, above which there’s no immediate price support/yield resistance, as one has to go all the way back to 2011 when the 10-year yield fell from 3.766% to 1.67% as the U.S. credit downgrade rocked markets amid QE2 and the European debt crisis.

It may not get there: recently PIMCO, which has turned decidedly more bearish on markets and the economy, predicted that buyers would promptly show up at 3% to keep yields from rising higher. Barclays strategists also said they’re sticking with their recommendation to buy at 2.9% or above with a target of 2.7%. Mitul Kotecha, a strategist at TD Securities, echoed that sentiment saying “ultimately it’s hard to see a move sustained above 3 percent on the U.S. 10-year. Some of the dialing down in tensions, in risk aversion, may be having some impact there as well as expectations of continued strong growth in the U.S.”

Meanwhile, unless the10Y can break above 3.00% in the next few sessions, pure technicals may push it lower as the RSI indicator shows 10Y notes are the most oversold in two months, even as net spec shorts remain at vastly elevated levels, potentially leaving the door open for a short squeeze.

One key variable to watch according to Hornbach will be 10-year breakevens, which briefly exceeded 2.195% on Monday, up from 2.05% points earlier this month, but has since fallen back as well. That suggests investors are starting to expect price growth that exceeds the Federal Reserve’s 2 percent target. To be sure, some of the inflationary pressure may subside, with the Bloomberg Commodity Index falling three straight sessions, after reaching the highest since 2015 last week.

If the breakeven rate continues to climb without the 10-year Treasury yield breaking 3 percent, that would likely signal a rally ahead, Hornbach said. The MS strategist noted three specific factors behind the sharp move wider in TIPS BEs:

  1. commodity prices rallying sharply,
  2. the perception that the Fed wants an inflation overshoot and
  3. deescalation of the tariffs rhetoric in favor of trade deals and negotiations.

In a Friday report, he wrote that “this breakeven widening has led the move higher in longer- dated nominal Treasury yields as well” and on Monday added on Bloomberg TV that “momentum in Fed policy has a lot to do with people’s forward-looking rate expectations. It’s one of these psychological phenomena where we look at what happened to us yesterday, and we think the next three years of our lives are going to be dictated by that.”

That said, here is what Hornbach believes will stop the breakeven widening:

Worsening supply and demand picture. We think the market will be surprised when the Treasury will announce addition of TIPS supply in the coming week. We think the Treasury will announce a new October 5-year TIPS in the coming quarterly refunding meeting increasing TIPS supply for the years to come. On the other hand, the demand picture for TIPS has started to look less positive than before as TIPS ETF inflows remain soft. Peaks and troughs in ETF inflows have led peaks and trough in breakevens in the past two years.

Ultimately, as Bloomberg commentator Ye Xie notes, it will be up to the market to decide just how different current market conditions are relative to the last time the 10Y made a run for 3% in February:

The February rout was driven by concern about wage inflation. The current yield increase seems to be triggered by a commodity surge. Different drivers will lead to different reactions from the Fed. While the Fed will come down hard on wage inflation, it can afford to look past temporary, supply-driven commodity-price increases.

That perhaps explains why rate vol remains relatively muted, and why stocks seem to be less concerned about rising yields. Equity investors can absorb an expected, gradual rise in inflation, but not the unexpected volatility shock.

If Yields Can't Breach 3.0%, What Then?

Perhaps it is indeed all about rates vol. If so, the 10Y may find less resistance than two months ago to sneak higher. On the other hand, should the MOVE volatility index spike (or the pension fund buyers we discussed yesterday make an early appearance), then watch out below (in yields).

Finally, there is the question of whether yields above 3% will crush stocks? As noted above, according to Gundlach the answer is yes; according to virtually all stock cheerleaders, the answer is a decisive no. Meanwhile, according to Goldman it depends on what is the actual rate of growth of the economy. According to the bank, as long as the 10Y remains modestly below 3.8%, it should be ok.

If Yields Can't Breach 3.0%, What Then?

Anything above that, either the economy will have to grow at a faster pace, or stocks get it.
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