Full reversion

A potentially explosive week ended with an implosion of yields, which fell sharply under the influence of an astonishing combination of factors acting in the same direction. Euphoric Wall Street celebrated the bond market’s rally with its best week of the year.

After briefly exceeding 5%, the yield on the 10-year T-Note fell to 4.5% last Friday, following the publication of a weaker-than-expected employment report. October’s 150,000 job creations and rise in the unemployment rate to 3.9% reflect a gradual rebalancing of the labor market. The increase in claims for unemployment benefits (217,000 according to the latest weekly figures) corroborates this observation.

On the other hand, the increase in job vacancies to 9.55 million is fuelling hopes of a “soft landing”, leading to an expansion that is “neither too hot nor too cold” (Goldilocks). Wage indicators support this diagnosis, as do average hourly earnings (up 0.2% in October, 4.1% year-on-year). More reliably, the employment cost index and “unit labor costs” are showing moderate growth, providing comfort to central bankers.

Unsurprisingly, the FOMC left its key interest rate unchanged last week. The statement includes a “hawkish bias”, but Jerome Powell’s words have reinforced the view that the Federal Reserve will not proceed with the threat of a higher rate hike that figured in the projections unveiled in September. By referring to significant progress on the inflation front and a tightening of financial conditions, the Fed boss has bolstered the case of those who believe that the cycle of interest rate hikes is definitively over.

In addition to Jerome Powell’s conciliatory stance, economic indicators played an important role in last week’s decline in yields. The fall in ISM PMIs (46.7 in October after 49 in September for the manufacturing index, 51.8 after 53.6 for services), the deterioration in consumer confidence and the cooling of the labor market mentioned above all point to a sharp slowdown after the surge seen in the third quarter.

Some believe that the “QRA” – the Quarterly Refunding Announcement by the US Treasury – has played a central role in the decline in yields that took place last week. This point is questionable, but the downward revision of the amounts to be borrowed during the fourth quarter has helped to allay the fears of those who believe that the recent rise in real yields sanctions US fiscal laxism.

In short, the bond rally (i.e., the decline in yields) is well supported by recent fundamental news, but Wall Street’s enthusiasm seems overrated. A soft landing for the US economy is not a foregone conclusion. The risks of recession or stagflation remain. The downturn in long-term yields is such that it is once again preferable to favour bonds with short and intermediate maturities (up to 7 years). On the other hand, the rally in long-term bonds and equities lends itself to opportunistic profit-taking.