Has the US Treasury Market Finally Accepted the Inflation-Free Growth Story?

I very rarely comment on day-to-day market movements since most observed price variation can be classified as noise. However, Friday night’s US Treasury market behaviour was fascinating. The main news of the day was an unexpected increase in US employment and the corresponding decrease in the unemployment rate to 6.3%. The following Bloomberg picture captures the tension between the bond market bears, who loudly call for higher interest rates, versus the largely silent bulls…

The story is the following. At 8:30 PM Singapore time, the US employment number was released and the instant reaction was a 1 point decline in the long bond future. This is what one usually expects to see since many market participants believe that stronger growth implies higher interest rates. However, the knee-jerk reaction was reversed over the subsequent three to four hours with the long bond not only erasing the loss, but rising almost 2 points above its low and finishing with a solid gain

My last blog cautioned against the crowded but vocal bear chorus, and it would seem that Friday’s trading session vindicates this warning. Why would interest rates fall on such strong positive economic news? I can think of a number of explanations.

Firstly, the brief but significant decline in Treasury prices afforded some of the nervous shorts an opportunity to close out. Secondly, and less likely, the decline in Treasury prices triggered purchases from foreign investors such as central banks and sovereign wealth funds, and maybe even the US Treasury itself. Thirdly, it may well be that the smart money is betting that the US economic recovery will be supply led which in turn places downward pressure on prices and inflation.

On reflection, the final explanation seems most likely since the 30 year interest rate should not be so heavily influenced by short-term traders, and the foreign investment community goes to great lengths to not impact the market.

Put simply, “inflation-free growth” would mean that the Federal reserve does not need to raise interest rates long after tapering has finished.

Being long the bond market seems a comfortable place to be.