The slow and relentless rally in the bond market has been anything but traditional because no one is waving the white flag over a drastic slowing in the U.S. economy or a collapse in risk assets.
Although first-quarter growth forecasts have dropped toward 1 per cent (which now seems to be an annual event), our second-quarter forecast sits at a very robust 3.3 per cent. We could be very wrong, but the Federal Reserve's probable course of action wouldn't change even if growth came in at 1.5 per cent with a 4.5-per-cent unemployment rate. Also absent in this bull market is a precipitous drop in crude that has moderated inflation fears in past rallies. In fact, oil is comfortably back above $50 a barrel after an early March swoon sparked by unfounded concerns about a glut of supply. And with labour markets drum-tight, upward wage pressure is certainly possible. So, with growth coming in above potential and inflation at or near the Fed's targets, much of the causation of this latest move in bonds falls into two categories: Washington gridlock and geopolitical fears.
Without a doubt the markets were too giddy after the U.S. elections regarding the Trump administration's ability to quickly deliver tax cuts and infrastructure programs. That became clear in the difficulty of reconciling the diametrically opposed factions of the Republican Party -- and White House inexperience -- in the debacle over repealing and replacing Obamacare. Regulatory reforms are easier, with some executive orders in process. The upshot of the health-care repeal failure was a drastic reduction in expectations of the scope and timing of a reform of a horribly complex system tax system with a countless number of entrenched special-interest constituencies. Hopes for a late summer or early fall shrunken tax plan have fallen by the wayside.
The Freedom Caucus flexed its muscles successfully in health care, and they will be vigilant in terms of preventing any budget-busting tax cuts, insisting on painful spending cuts in turn -- anathema to both Democrats and moderate Republicans. Handicapping the outcome is near impossible given the complexity of the issue, the warring nature of the participants, and the opacity of the White House's desires. The ability of a White House with the lowest voter approval ratings in history to bully Congress is doubtful. The Fed has told us that the success of fiscal reform is not built into their forecasts, and their skepticism looks sensible and in tune with the market's reduced expectations.
With Washington gridlock the norm, we can turn to the geopolitical narratives that have seemed to be main drivers of this bond rally. The initial and most relevant trigger was the cruise missile attack on the Syrian airfield in response to the use of chemical weapons by the regime of President Bashar Al-Assad of Syria against the country's rebel forces. The attack was anything but random. It was a highly focused warning shot, made more effective by its sharp divergence from the Obama administration's cautionary stance. But it won't lead to U.S. boots on the ground. Nothing has changed in Syria and its relevance as a flight-to-quality trigger is minimal. The second geopolitical flash point is North Korea. Unlike in the Middle East, no shots have been fired but the potential for a cataclysmic event is much higher given the unpredictable nature of North Korean leadership. The country's nuclear weapons program leaves Japan and South Korea in a state of permanent dread. While the threatening language from the Koreans has escalated, has anything really changed much? Yes, a U.S. Navy carrier group turned back north toward the Korean peninsula, but steaming around in international waters off the coast of our ally South Korea is nothing new. The North Koreans always threaten to destroy the South and its American protectors, but they know that even the slightest hint that they were about to use a nuclear weapon would result in the destruction of the country.
What has changed is the willingness of the White House to use U.S./China relations as a lever to force Beijing to rein in their Korean client state via economic means. The Korean standoff has been with us for almost 70 years, the patterns are well-entrenched. Again, it isn't clear why this situation should trigger massive risk-off flows or shift the U.S. monetary policy path.
The final piece of the geopolitical risk puzzle is the French election. The betting odds remain biased toward a win by centrist Emmanuel Macron. And while the surprise pro-Brexit vote in June that led punters to happily grab 10-year Treasury notes paying yields of just 1.375 per cent could be a useful road map in case of a shock victory by nationalist Marine Le Pen, peaceful transition in a Western democratic society cannot be compared to U.S./Russian conflict in Syria or war in Korea in terms of risk-off shock value.
These geopolitical flare-ups appear to be more smoke than fire at this juncture. Combined, they have had a big impact on the willingness of many bond traders to continue their bearish outlooks as the Fed looks to accelerate its tightening cycle. From an insider's vantage point, this rally has been less dramatic than those seen in prior years. The market can be seen as in balance, with the short base steadily thinning out as the technical breakout brought in momentum traders.
As the market makes new highs and establishes a new trading range, it seems that the "Trump trade" positions have been mostly washed out. At some point the market will revert to a traditional focus on the solid U.S. fundamentals and Fed rate hikes. There are no major data releases until April 26, and the Fed is sidelined for two long months, so until then the flows and charts dominate.
Scott Dorf is a managing director at Amherst Pierpont Securities. He has been selling and trading U.S. Treasuries for more than 30 years.