U.S. Treasuries – Fundamentals Of The Treasury Market

The long bond sold off sharply from the end of August until September. It has been steady in October. The question is where it moves next. Personally, I look at the bond market as a signal of the economy. From that, I use my opinion of the economy to predict where it goes.

The selloff late in the summer caught me by surprise. But it needs to continue in October before I start to question my expectation for a slowdown in 2019. My prediction is that year over year inflation growth will fall in the next few months.

In a previous article, I showed the net short position in the 10 year bond is at a record high. This implies there could be a steep decline in yields.

Generally, you don’t want to be in a trade that is overly crowded. The bad news for the treasury market is there will be an increase in supply in the coming quarters.

Budget deficit has increased 17% to $779 billion because of spending increases. The deficit is the highest in 6 years.

Fiscal revenue increased $14 billion and outlays increased $127 billion which is a 3.2% increase. Spending increase came from defense, Medicaid, social security, and disaster relief.

As you can see from the chart below, usually the deficit increases when the economy is weak and decreases when the economy is strong.

However, this year is an exception as the economy has been strong, but the fiscal stimulus catalyzed a bigger deficit.

It’s rare to see such a large stimulus at this point in the cycle. Technically, we can’t prove what point in the cycle we are in. Indicators like the unemployment rate, output gap, and the length of the expansion signal this stimulus could be the latest one ever.

U.S. Treasuries – The interesting aspect of this timing is figuring out the effect on the treasury market.

Usually, there is strong buying in treasuries during recessions in a flight to safety trade. In this environment, there is no flight to safety and supply is increasing.