Oil, bonds divergence highlights US fiscal fears: McGeever
Repeats Oct. 30 column without change
By Jamie McGeever
ORLANDO, Florida, Oct 30 (Reuters) -U.S. Treasury yields often move in tandem with the price of oil, but this relationship has broken down in recent weeks, suggesting that the near-term inflation outlook has taken a back seat to long-term deficit fears in the bond market.
Falling oil prices – especially negative year-on-year price moves – are usually disinflationary. And year-on-year crude oil prices have been negative since mid-July, nearing -30% in September. This would typically be a bullish signal for Treasuries, as lower inflation increases the likelihood that rates will fall across the yield curve.
Yet yields and oil have diverged sharply. Since the Federal Reserve's jumbo 50 basis point rate cut on Sept. 18, the 10-year Treasury yield has spiked by almost 70 basis points – a historically large shift – even as the price of oil has fallen.
Monday's price movements were particularly noteworthy. Crude slumped 6%, while the 10-year yield leapt 5 bps to hit 4.30% for the first time in nearly four months.
Oil's recent decline was primarily driven by geopolitics, specifically signs of de-escalation in the conflict between Iran and Israel. Regardless of the driver, a fall in oil of that scale would normally be accompanied by lower bond yields.
The 10-year yield has declined on seven of the nine days in which the oil price has fallen by 4% or more over the past year. The two occasions where it hasn't were both this month.
Importantly, the recent rise in yields coincided with a week of heavy debt issuance from the Treasury: some $178 billion of two-, five- and seven-year bonds were on the block, not to mention a wave of bill sales and inflation-linked bonds too.
Fiscal issues nay be causing this market indigestion.
TRUMP TRADE
Can investors expect the relationship between Treasuries and inflationary pressures to reassert itself any time soon?
Bob Elliott, a former executive at Bridgewater and founder and CEO of asset manager Unlimited, notes that other bond markets around the world are also selling off, indicating a wider issue.
"My sense is the divergence stays rather than compresses. It highlights that sovereign debt is increasingly out of favor for not just U.S. but global investors," Elliott says.
Andreas Steno Larsen, CIO at Steno Global Macro Fund, reckons the link will probably reestablish itself soon, but notes that the current divergence is one element of the wider "Trump trade".
That is, investors are positioning for extremely lax fiscal policy, with the expectation that former president Donald Trump will win the White House and possibly be supported by both a Republican house and senate. In that scenario, Trump would be able to push through tax cuts and other potentially budget-busting policies.
LOSING CONTROL?
The prospect of rising bond yields amid a Fed easing cycle could cause headaches for many, including Trump himself, a former real estate operator and long-time vocal advocate of lower borrowing costs.
This may also be rustling a few feathers on the Federal Open Market Committee, particularly among the doves, as mortgage rates are rising again due to the upward pressure of longer-dated yields.
Could Fed Chair Jerome Powell address this issue next week? It wouldn't come as a total shock given the massive move in yields since September.
According to Jim Bianco of Bianco Research, the 10-year yield's rise of almost 70 bps is the biggest rise following the initial cut in a Fed easing cycle since 1989. This super-sized move suggests the Fed may have lost control of the longer end of the curve, and Powell may be eager to regain the reins.
But, for now, politics remain in the driver's seat. With the presidential election less than one week away, bond investors appear to be voting with their feet, fearful that widening fiscal deficits will push up longer-term inflation and the risk premium on federal debt.
Perhaps this will change after the election. Maybe President Kamala Harris or President Trump will unexpectedly vow to restore fiscal discipline, but that's a long shot. In the meantime, Treasuries are likely to remain under pressure, regardless of the oil price.
(The opinions expressed here are those of the author, a columnist for Reuters)
U.S. Treasuries, oil diverge sharply https://tmsnrt.rs/3UshPtN
U.S. 10y yield's biggest rise after maiden Fed cut since 1989 https://tmsnrt.rs/4hklLXd
U.S. 'term premium' up sharply after Fed rate cut https://tmsnrt.rs/4e0MUeU
By Jamie McGeever; editing by David Evans
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