Powell and Fed have zero control over the long bond

Day two of Federal Reserve Chairman Jerome Powell’s congressional testimony was much like the first. He reiterated that the economy is “in a very good place,” but that the central bank has room to lower interest rates to keep the expansion on track. As dovish as that may sound, the comments didn’t offer much comfort to bond traders – they had other things on their minds.
For the second time this week, the US Treasury held a bond auction that met with less than stellar demand, triggering losses across all maturities and pushing yields on longer-dated debt to their highest since May. Investors submitted bids for just 2.13 times the $16 billion of 30-year bonds offered. To put that in perspective, consider than in the almost 50 auctions of that maturity since mid-2015, the bid-to-cover ratio has been lower just three times. Not only that, the yield of 2.644 percent was higher than the 2.618 percent the securities were trading at just before the auction, generating the highest so-called tail since early 2016 and confirming the weak demand.
“Friendless long bonds abandoned at sale,” is how FTN Financial interest-rate strategist Jim Vogel titled his report on the auction. While short-term debt is highly influenced by the direction of monetary policy, longer-term securities are more sensitive to things like inflation and perceived creditworthiness. And in that regard, bond investors have plenty to worry about. The government said just a few hours before the auction that the core consumer price index, which excludes food and energy, rose 0.3 percent from the prior month, the most since January 2018 and enough to raise doubts about the notion that inflation really is dead.
There other good reasons for bond investors to be cautious on longer-term US debt. The Trump administration is openly talking about how it would desire a weaker greenback, which for many is a sign that the US is abandoning its long-held strong-dollar policy. Put another way, who wants to hold long-term, dollar denominated assets while the US government is doing everything it can short of actually intervening to weaken the dollar? As for the creditworthiness of the US, the Treasury Department said after the auction that the budget deficit widened by 23 percent to $747.1 billion in the first nine months of the fiscal year. Prospects for faster inflation, a falling dollar and more borrowing isn’t a recipe for a bull market in bonds.
Although the Dow Jones Industrial Average closed above the 27,000 market for the first time, the more important S&P 500 Index rose above 3,000 for the second straight day only to fall back to just below that level to 2,999.91 by the end of trading. Given how important falling bond yields have been to the rally in stocks, it was impressive that equities didn’t fall out of bed along with Treasury market. The reason may be found in the CPI report. The thinking here is that if inflation really is accelerating, then perhaps companies will finally be able to pass on price increases to their customers, reversing the trend towards narrower profit margins. “The June CPI report vindicates Chair Powell’s earlier assessment that some of the recent slowdown in inflation was at least partially due to transitory factors,” Bloomberg Economics’s Yelena Shulyatyeva wrote in a report. Profit margins for S&P 500 companies have narrowed from 12.6 percent in last year’s third quarter to a likely 11.7 percent for second quarter, according to Bloomberg Intelligence. “The forecast for double-digit net income growth by this time next year won’t happen without margin gains,” the strategists with Bloomberg Intelligence wrote in a report.
Trump will get a weaker dollar, just probably not as weak or as soon as he wants. Although the US Dollar Index has fallen to 97.064 from this year’s high of 98.203 in April, the median estimate of currency strategists surveyed by Bloomberg is for it to drop to 95 by year-end. That would only put the gauge at its lowest since October — not enough to do a lot for exporters, considering it was below 90 in early 2018 and around 80 in mid-2014.
As such, the new favourite parlor game in currency market is speculating on whether the US might intervene to weaken the dollar, and if so, how it might accomplish that feat. It wouldn’t be easy. The US would likely need the help of other nations, because the $5 trillion-per-day market is too deep for unilateral US action to have any impact. And given how quickly the global economy is weakening, the US would be hard-pressed to get any other nation to help it push the dollar lower, as that would have the effect of strengthening their own currencies. The most effective move might be the simplest. All the US would have to do is officially abandon the strong-dollar policy introduced in 1995, according to the strategists at Bank of America Merrill Lynch. Such a shift could be a “game-changer,” the strategists wrote in report. But that brings up another set of problems, such as international investors potentially shunning dollar-based assets and causing US borrowing costs to rise. Was the 30-year bond auction a glimpse of the future?
The euro zone economy is worse off than the US and the Bloomberg Euro Index is down about 5.50 percent since April 2018. And yet, emerging-market borrowers are issuing debt in euros at a record pace to meet demand, another sign that perhaps investors might be shunning the dollar. Emerging- market sovereigns have collected 33.5 billion euros ($37.7 billion) from new bonds his year, more than the amount raised in any full year previously, according to Bloomberg News’s Srinivasan Sivabalan. Togo, the tiny West African nation with a gross domestic product that’s less than the annual revenue of 70 percent of the companies in the S&P 500 Index, was the latest to borrow in euros.
—Bloomberg

Robert Burgess is an editor for Bloomberg Opinion. He is the former global executive editor in charge of financial markets for Bloomberg News. As managing editor, he led the company’s news coverage of credit markets during the global financial crisis