Are US yields on the verge of a deeper decline?

Summary:

• Federal Reserve rate hike in September has been almost fully priced in

• Speculative positioning on gold, VIX, US 10Y notes suggests that a massive short squeeze might be on the cards

• SP500 and US 10Y yield correlation implies a possible decline in the latter once risk appetite fades

• US 10Y yield breaks its medium-term trend line opening the way for a deeper pullback

• US 10Y note price (T-Note on xStation5) draws encouraging bullish patterns

Bets on the stronger dollar have substantially increased of late and this has corresponded with heavy declines in terms of the net speculative positioning on gold and US 10Y notes. In this analysis we are putting forward some arguments behind the thesis that the US 10Y yield may be on the verge of a deeper decline in a relatively short term horizon.

The market has already taken the hike in the following month for granted seeing more than 50% chances for the fourth rate increase until the year end. Source: Bloomberg

Since the peak reached earlier this year (slightly above 3.12%) the US 10Y yield has moved below 2.9% over the recent days. Notice that the slide has been buoyed by an inflow toward safe haven assets amid increased risk aversion resulting from a turmoil around Turkey as well as Italy. As of yet, neither concern has abated and there is a likelihood that the US 10Y yield (and yields in general) might find itself under downward pressure in the upcoming weeks. The first reason suggesting that there could be little fuel left for higher yields is the market’s pricing of Fed rates hikes till the end of the year. The rate increase in September has been discounted in 90% while market participants assign almost 55% odds for another (the fourth one) move in December - calculations based on Fed Funds Futures. It is worth adding too that Trump’s remarks regarding the US monetary policy, the dollar and currency manipulations in Europe and China also seem to suggest that the US President does not want to see the much stronger currency. Although Trump itself will not stop the Federal Reserve, his rhetoric could be US dollar negative. Note that comments pertaining to currency manipulation send a clear message that Trump would like to see the weaker dollar as it would cushion exporters amid widespread trade tensions.

Net speculative positioning slumped massively on gold, VIX and US bonds suggesting that investors may have become too complacent. Source: Bloomberg, XTB Research

As we pointed out at the beginning of this analysis, speculative investors have become remarkably bearish on gold and bonds expecting higher stock prices and low volatility. This seems to be a perfect mixture to witness a massive short squeeze. Beginning with the US 10Y note we may say that the net short position has already reached its highest level on record. The net speculative position on gold has turned negative for the first time in 17 years whereas the positioning on the VIX index (the instrument giving an exposure to volatility over the next 30 days in the SP500) is hovering close to its historical low levels. By and large, it all implies that speculative investors are not afraid of any financial tailspin what paradoxically increases the likelihood to see a pick-up in risk aversion leading to tremendous short covering and thereby pushing US 10Y bond price much higher. At the same time we would probably experience corresponding moves in gold prices as well as the VIX index. Taking into account that the summer lull is slowly coming to an end this scenario does not seem to be completely unrealistic.

The 120-day rolling correlation coefficient between the SP500 and the US 10Y yield has been climbing since the beginning of 2017. Source: Bloomberg, XTB Research

Taking into account how speculative positions on the VIX, SP500 and US 10Y bond look, one may suppose that a squeeze on the bond market market appears to be very likely. What would happen if such a scenario materializes? The chart above illustrates the 120-day rolling correlation between the SP500 and the US 10Y yield which has recently reached its highest level since mid-2016 of over 0.4. It implies that under circumstances of increased risk aversion,  which could deplete US equities’ valuation, one may anticipate a corresponding move in US yields (note that investors tend to park their cash in US bonds or notes - depending on which duration we are talking about - when volatility increases). Given that the SP500 is just shy of its new high (it basically did reach a new all-time high during the session on Tuesday but failed to retain gains until the end of trading) one may suspect that there could be an increasing number of investors who would want to close their positions and book gains.

The US 10Y yield has already broken down its medium-term trend line being a convincing signal for bears from a technical viewpoint. Source: Bloomberg

Finally, let’s take a closer look at the chart presenting the US 10Y yield since May 2017. The yield has been rising basically since a trough made in September last year reaching its top in May. Over this period the price has strictly respected the medium-term trend line until this week when the line has been broken down. Technicians could even read a possible head and shoulders formation into this chart which would justify a pullback even below 2.5%. Anyway, the technical outlook seems to be unequivocally supportive of bulls (looking from the price’s perspective) adding up to the above-mentioned factors.

The final chart depicts the price of the US 10Y yield (T-Note on xStation5) which could look also encouragingly for bulls. Note that we were offered two back-to-back bullish patterns over the past weeks and the second one (the morning star) occurred at a higher level compared with the first one (the bullish engulfing). Therefore, we are recommending to go long at a market price with a target at 125 (do note that the price may face some difficulties around 122.5 - the 23.6% retracement) and a stop order at 118. Source: xStation5