Yesterday’s 1,200 point reversal in the Dow, from the overnight futures low to the high, was not a one-day wonder. Stock traders are adding to the gains this morning. Dow futures are up 100 points (a high of +180) in pre-opening trading as stock traders focus on the possibilities of the shorter-term good that could come from Trump’s policies (tax and regulation relief for business) and ignore the potential longer-term negatives (higher deficits and inflation). The Dow is on pace for its best weekly gain in five years and could post a new all-time high.
More stunning and surprising was yesterday's demolition in the bond market. Bond traders immediately started to focus on the potential longer-term negatives of Trump’s plan. The 10-year yield rose the most in a single day in five years. The 30-year bond lost 5% of its principal value in one-day. That annual yield of 2.5% doesn’t look so good anymore.
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The Ongoing Rally Problem
The striking thing from yesterday was how the bond market had no bounce at all during the day. The heavy selling was mostly by the large, leveraged funds. Investors, supposedly yield-starved, did not view this as a buying opportunity. Bonds did rally early in trading last night during Asian hours, however. The 10-year yield fell from 2.07% to 2.01%. But that rally failed during the rest of the overnight trading hours. The 10-year yield is currently 2.115%.
The move in bonds yesterday was likely exaggerated by the lack of liquidity in the bond market, though using the word exaggerated is not really correct. Exaggerated means something out of the norm, and the lack of liquidity in the bond market has been an ongoing problem. We’ve seen that when bonds are rallying on thin volume, and now we’re seeing it play out in a selloff. But make no mistake about it, yesterday’s bond rally was in heavy volume and the dam seems to be breaking.
The bond market’s problem has roots going back to August when Japan's central bank cooled to increasing bond purchases. That was followed by a similar message from the European Central Bank. At that time, the big leveraged accounts started getting nervous, and now with the Trump victory they have a real problem on their hands. Inflation expectations are shifting, and bond yields are horribly mispriced relative to inflation.
Something could certainly happen to turn the bond market around, but it will have to be something big to keep this recent psychological change in the bond market from establishing a base for a new longer-term trend to higher rates. What the bond market needs soon is a good old-fashioned European crisis. That’s worked several times over the past few years to help keep rates artificially low. The long-term trend to lower rates began in 1982. If July 7, 2016 was the turning point, the trend has had a good run.
One thing we know is that bond prices will not fall tomorrow. It's Veterans Day. The bond market is closed.
Dwight Johnston is the chief economist of the California and Nevada Credit Union Leagues and president of Dwight Johnston Economics. He is the author of a popular commentary site and is a frequent speaker at credit union board planning sessions and industry conferences.