The Fed Is About To Hike: Why That Is Bullish For Bonds

With the market pricing in near certainty of a June rate hike despite the Fed’s tacit warning that it would like to see evidence the recent economic slowdown is over, a recurring question among trading desks is why aren’t long-dated bonds selling off more, or rather why is the 10 and 30Y seemingly bid the closer we get to the next Fed hike with everyone – from hedge funds, to central banks to primary dealers – buying in surprising amounts.

Overnight, an answer came from Wes Goodman, a Bloomberg columnist, who explains that the more the Fed hikes, the more bullish it is for bonds, i.e., the entire market is once again betting on “policy error” by the Fed.

Here is latest Macro View note titled “The Fed Is Going to Hike. That’s Bullish for Bonds“

The Fed’s likely rate hike next month will probably send Treasury yields lower, and investors from hedge funds to banks are loading up on U.S. government debt ahead of the move.

Contrary to conventional wisdom, Treasuries have rallied following the last three rate increases. Instead of sending yields higher, the hikes are driving speculation that rising short-term borrowing costs will curb the economic expansion and make it tougher for the Fed to sustain its 2% inflation target.

Hedge funds and other large speculators boosted their net long position in 10-year futures to the highest level in almost a decade.

U.S. commercial bank holdings of Treasuries and agency debt surged the most in 16 months in the latest weekly data, extending a record high.

Treasuries held by foreign central banks in custody at the Federal Reserve rose this month to the most since June 2016.

Primary dealer holdings of U.S. government securities have surged 50% from this year’s low in March, and they’re now about even with the average over the past 12 months.

Goodman’s conclusion: “All this demand may be enough to drive benchmark 10-year yields to a new low for 2017, below 2.16%.”

Of course, if this is correct, the implication is that the higher the Fed hikes short-term rates, the lower long-term rates go, flattening the curve and eventually inverting it. And, at some point in the near future, this will once again bring up the even more ominous question: is the Fed once again making a policy error by hiking into an economy that can not sustain it. For now the jury is out.