This week, the Fed announced a reduction in its bond purchases. In separate news, the Big Jobs report was much stronger than expected. These two events should have pushed up rates. So why didn’t they do it?
Let’s start with the Fed and its bond buying adventures (also called QE or “quantitative easing”). The following chart of 10-year Treasury yields (a broad benchmark for “rates”) shows the paradoxical reactions to previous decisions by the Fed to stop buying bonds.
In other words, we knew that a paradoxical reaction was a possibility, even if the precedent is never a guarantee. Beyond that, we also knew that rates were rising in anticipation of a possible Fed exit. In fact, last week they had already covered as much ground as in 2013.
All this to say that the reaction to the Fed’s announcement has undoubtedly been in the works for over a year. In this sense, it is certain made push rates higher, but well in advance. September 22 provided the most recent example when the Fed most openly telegraphed the contents of this week’s announcement.
Incidentally, the bond market’s first reaction to this week’s tapering announcement was also to raise rates slightly. The recovery did not take place until the next day. So what caused this drop in yields? And how about the even more puzzling drop the next morning after the solid jobs report (the two “drops” seen in the red-highlighted areas below)?
These kinds of pops and drops rarely boil down to a single root cause. Some traders don’t even take these timely events into account. But if we had to choose only one prime suspect – the unexpected catalyst for most other drama – would be the Bank of England (BOE).
The BOE ?! Is it even important at rates in the United States?
Yes, in fact, there is a strong correlation between bond yields in the United States and Europe. Each will take turns drawing inspiration from the other. Correlations are particularly noticeable when one of the major central banks triggers a large variation in the yields of the sovereign debt of the country concerned.
In other words, if the BOE does something to bring UK bonds down sharply, it will almost always result in at least some downward pressure on US bond yields. With that in mind, let’s take a look at another version of the chart above. This time, we’ll take a look at the outright change in US 10-year yields since Tuesday, and compare it to the outright change in UK 10-year yields.
On the contrary, the US bond market was trying to resist the attraction of the UK bond market on Thursday. When the onslaught continued on Friday, it forced traders to close (or “hedge”) bets on higher yields (aka “short positions”). The result is known as a “short squeeze”, and its momentum is only limited by the number of short positions in the market (and there were a ton of them).
At the end of the line : a series of surprisingly favorable events for UK bonds spread and put downward pressure on US yields. US traders weren’t prepared for yields to fall so low and therefore were forced to capitulate by buying more bonds (which pushes yields even lower) in order to close their short positions. Finally, if we had any doubts about the British inspiration, we can simply observe the red line falling more than twice as much as the blue line since Tuesday.
In a much larger picture, we can also keep an eye out for changes in the relationship between covid and the market. To some extent, we are seeing a similar pattern to that seen earlier in 2021, when the number of cases has stopped falling and rates have stopped rising.