Morning Notes — Bond Market Catalysts Ahead

Bond yields: The bond market has been under consistent bearish pressure over the past 5 weeks despite deeply oversold conditions.  During that time, 10-year bond yields impulsively broke through three consecutive resistance levels with the most recent break occurring at 1.62%-1.70%.  The November 9 vaccine data initially pushed bond yields to 0.925%, giving us a first look at the developing bond bear market.  At the time, we expected the bear market to unfold in a stair-step fashion, but rising expectations for increased fiscal stimulus changed the roadmap.  The December fiscal stimulus package worth $900B resulted in January retail sales (control group) reaching a pre-pandemic record of +8.3%.  The recent $1.9T fiscal package combined with an economic reopening (US still on track to reach herd immunity by the end of April) will likely produce some extremely punchy inflation readings this spring/summer.  The Fed has been messaging that any  inflation spike will likely prove transitory.  That’s an easy statement to make given Covid base effects and a reaction function based on average inflation running above +2%.  But market participants are charged with a more forward-looking mandate and have to price-in some probability of a more enduring reflation.   

Wiggle: Quarter-end pension fund rebalancing should provide incremental support for bond prices into month-end.  But intermediate-term positioning dynamics for bonds took a step back Friday when the Fed decided to let the Supplementary Leverage Ratio (SLR) relief expire on 3/31.  Allowing SLR relief to expire means commercial banks with stretched balance sheets (too many deposits/too few loans) may need to slow the acceptance of customer deposits.  Fewer deposits requires fewer assets as a balance sheet offset, which means reduced Treasury demand from some large commercial banks.  Positioning dynamics always take a back seat to fundamental drivers, but the net set-up should help bond yields stabilize over the next few sessions.  After 3/31, bond market supply/demand positioning dynamics will revert to becoming a net-headwind for prices.  As for fundamental drivers, keep an eye on tomorrow’s release of March flash PMIs (consensus for manufacturing PMI is 59.4 and services at 60.1) and Friday’s release of core PCE for February (consensus at +0.1% month-over-month vs +0.3% in January). 

Sectors/sub-industry: A near-term reprieve in the bond yield backup based on pension fund rebalancing or in-line/disappointing data would allow growth sectors to recover, while value sectors unwind from short-term overbought levels.  Any pullback in value sectors to oversold levels should be viewed as an opportunity to add exposure. Financials remain our favorite value sector with regional banks as our preferred sub-industry.