While the global pandemic has faded into the market’s rearview mirror, the impact of a tidal wave of central bank liquidity and government stimulus remains a legacy. Bond futures spiked higher in a flight to quality in March 2020. After running out of upside steam, the bonds have made lower highs and lower lows for over two years.
Inflation rose to a four-decade high when the U.S. Fed reversed course and tightened credit. The Fed waited too long to address rising prices, but the shift to a hawkish monetary approach pushed the short-term Fed Funds Rate 5% higher since March 2022. The long bond futures and iShares 20+ Year Treasury Bond ETF product (TLT) remain in bearish trends in late May 2023, but the path of least resistance could be running out of downside steam.
Bearish bond trends in the U.S. – The Fed reached one target
The Fed’s target for the Fed Funds Rate in 2023 was 5.125%. It reached the goal at the May FOMC meeting, which increases the chances of a pause in rate hikes at the upcoming meetings. Meanwhile, the central bank’s 2% inflation target remains elusive. If the economic condition rises, the Fed could move the goalposts on the Fed Funds Rate higher.
Meanwhile, the bearish trend in the long bond futures continues at the end of May 2023.
As the five-year chart highlights, the U.S. 30-Year Treasury futures have made lower highs and lower lows since March 2020, reaching a 117-19 low in October 2022. Since then, the bonds have traded in a 121-27 to 134-14 range. While the long bond has not broken out of the bearish path of least resistance, the short-term trend has exhibited higher lows and higher highs since the September bottom. The bonds are waiting for the Fed and other economic data to decide if they will continue to decline or if an upside breakout is in the cards.
Debt ceiling compromise could lift bonds
According to U.S. Treasury Secretary Janet Yellen, May 29, 2023, is a few days before the deadline for increasing the debt ceiling. The Treasury likely has some room before a default, but the line in the sand is near or has arrived.
While the administration and House Republicans have negotiated the terms for an agreement to increase the U.S. debt ceiling, each political party must agree on the deal but cannot afford to cause the first U.S. default. Henry Clay, the U.S. Senator and Presidential candidate in the 1800s was the Great Compromiser. His formula for a “great compromise” is when both parties leave the table unhappy. The bottom line is that a compromise is not an option but essential in the debt ceiling negotiations. The far left and right are not happy with the agreement.
Avoiding default will allow politicians and everyone across the U.S. to breathe a little easier, and the bond market could rally and eclipse the early April 134-14 high on the June long bond futures when Congress approves a comprise increasing the U.S.’s borrowing level without defaulting on any obligations.
No compromise would have a tragic impact on bonds and markets across all asset classes
Meanwhile, no compromise that leads to the first default in U.S. history would be a disaster for markets across all asset classes, and the long bond futures are no exception.
The loss of faith in U.S. government debt securities and a credit downgrade would cause investors and bond buyers to insist on higher yields for U.S. bonds. Bonds would not be the only market to take it on the chin. The U.S. dollar would likely decline, commodity prices could rise as inflation increases, and stocks could plunge. Cryptocurrencies could take off on the upside as market participants scramble to park assets in alternative vehicles that tend to reject traditional stock and bond investing. Moreover, volatility would likely spike higher if the world’s wealthiest nation cannot pay its bills.
No politician wants responsibility – The odds favor a deal
The U.S. is divided, with Democrats and Republicans at each other’s throats. Extreme ideologies on each side of the political spectrum have created a vast gulf. The extreme left and right alone could never agree on the terms to increase the debt ceiling, given the debate over spending versus austerity.
Moderate politicians realize that negotiation and compromise are necessary to run the U.S. government and act responsibly. They realize there are no winners in a default. While each side of the debate will point fingers at the other, the voters would likely blame all politicians, whose favorability ratings are already very low. Therefore, the odds favor an agreement but those who wish to keep their seats in the legislature and administration with the 2024 presidential election on the horizon.
Bonds should remain stable – Any rate hikes would be nominal – Buy bonds on dips
While the long-term trend remains bearish, the short-term path of least resistance in the long bonds suggests an upside breakout and significant recovery could be on the horizon.
The two-year long bond futures chart shows a mostly sideways trading pattern with a slight upward bias.
The two factors that lead to a bullish view are that at 5.125%, any increases in the Fed Funds Rate over the coming months will likely be marginal. Meanwhile, the high odds of a debt ceiling increase will take downside pressure off the long bond.
The iShares 20+ Year U.S. Treasury Bond ETF product (TLT) is a highly liquid ETF with the same short-term bullish trend as the long bond futures.
The chart illustrates TLT’s slightly bullish trend. At just over the $100 per share level on May 26, TLT had over $34.43 billion in assets under management. TLT trades over 22.375 million shares daily and charges a 0.15% management fee.
The bearish trend in bonds and the TLT since 2020 remain intact at the end of May 2023. Still, the odds of stability or a significant recovery are rising with a settlement of the debt ceiling issue and the Fed’s likely rate hike pause over the coming months. The case for owning bonds is improving, and only a default or spike in inflation could derail a potentially bullish period in the government bond market
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