Why the US Treasury Rally is Over

The relentless rally in US Treasuries has stunned both Investment Banks and the most astute market observers who have long called for higher yields. Over the course of this year US Treasury yields have dropped relentlessly, burning all who dared to speculate yields would rise. Yet it seems that the fundamentals and tactical indicators have finally turned against US Treasuries in a decisive manner. As a result, it is my view that the rally in US Treasuries has come to an end. In this short article I will explain why I believe this to be the case.

The US Federal Reserve has been warning us for a long time.

Over the course of 2014, the gap between what financial markets are pricing in for US interest rates on the one hand and the US Federal Reserve’s (FED) own projections on the other hand has grown (Figure 1). Looking at the last release of the FED’s now famous interest rate “Dots” in June, it is clear that the FED Fund Futures is pricing a much lower interest rate trajectory than the median of the FED “Dots”.

Figure 1: The massive gap between market futures pricing and the June FOMC “Dots” (Source: Fidelity)

This massive discrepancy between the FED’s own projections and the market expectations has been a growing concern for the policy-setting Federal Open Market committee (FOMC). As a result, many of the FOMC’s most vocal proponents of tighter policy (aka “Hawks”), including Richard Fisher, Jeffrey Lacker and Esther George, have addressed the media in numerous speeches and television appearances. This seems like a desperate attempt to realign the market with the FED’s own projections.

Looking at the following highlights from their media appearances, the message they are trying to convey could not be clearer.

Highlights from Federal Reserve Bank of Dallas President Richard Fisher’s interview on Fox Business Network on August 5th, 2014 (via the Wall Street Journal):

He told Fox Business Network he refrained from voting against his colleagues because “things have been coming my way” and Fed officials are increasingly in agreement with the idea that if the economy continues to improve, the time to raise short-term interest rates may be approaching. The official said if the Fed debate “doesn’t keep moving in my direction, I will dissent.” Mr. Fisher also said that if economic data continues to come in strong, “we are going to have to move forward the date of liftoff.”

Highlights from Federal Reserve Bank of Richmond President Jeffrey Lacker’s interview with Bloomberg News on August 1, 2014:

Short-term interest-rate markets have for months priced in a slower tempo of increases than policy makers themselves forecast. That’s risky because the misalignment, a bet against a rate path that the central bank alone controls, could lead to volatility if traders have to adjust rapidly, Lacker said in an Aug. 1 interview at his Richmond office overlooking the James River. “When there is that kind of gap, it gets your attention. It wouldn’t be good for it to be closed with great rapidity.”

Highlights from Federal Reserve Bank of Kansas City President Esther George’s interview with Bloomberg News on August 21th, 2014 at the Jackson Hole Symposium:

“We have seen significant progress in the labor market over the last three years, and particularly this year. As we look at the healing we’ve seen in the economy and that progress, we’re in a good place to begin talking about normalization.” George said in a Bloomberg Television interview in Jackson Hole, Wyoming.

Yet even with these obvious warning signs coming from the “Hawks”, markets have chosen to ignore their warnings in the belief that much of this rhetoric will be overpowered and ignored by the more “Dovish” elements of the FOMC. Yet markets could be grossly mistaken in this respect. 

The release of the latest FOMC minutes on August 21th, 2014 conveyed a more “Hawkish” message than market participants had expected. It showed that the committee was willing to raise interest rates sooner than anticipated if economic data came in stronger than expected.

The following highlight from a Bloomberg article says it all:

In the minutes, Fed officials “noted that if convergence toward the committee’s objectives occurred more quickly than expected, it might become appropriate to begin removing monetary policy accommodation sooner than they currently anticipated.”

Once again the markets chose to this disregard this obvious warning. Instead, market participants placed all their bets on the “ultra-Dovish” Federal Reserve Chairwomen Janet Yellen and her Jackson Hole Symposium speech. Janet Yellen is one of the most vocal proponents of a loose monetary policy and at the same time she’s also the FOMC’s most influential member. This led market participants to expect that she would express her “Dovish” view during the Jackson Hole Symposium, and that in doing so she would neutralize the more “Hawkish” sentiment of her counterparts. Surprisingly, Janet Yellen chose the middle ground and delivered a more nuanced speech than investors had expected: