Weakening Global PMI Leads to Treasury Rally

April 4, 2019

Source: Bloomberg Source: Bloomberg

Over the last several decades, manufacturing as a percentage of the overall economy has declined. However, the manufacturing sector has much higher cyclicality than the service sector. As a result, the manufacturing Purchasing Managers’ Index (PMI) is still an important leading economic indicator for investors to gauge the strength of the economy.

Looking at this week’s chart, we can see that the global manufacturing PMI peaked in early 2018 and has been in a downtrend since. U.S. manufacturing PMI reached its high in mid-2018, whereas German bunds and China government bond yields have followed suit, decreasing since January 2018. 

The U.S. Treasury yield sold off in 2018 because of the rate hike from the Federal Reserve (Fed) and a strong domestic economy. However, U.S. Treasuries rallied sharply to-date in 2019, particularly over the last two weeks. Between March 19 and March 27, the 10-year U.S. government bond rallied 25 basis points. Considering the interest rate volatility market, the recent move is even more extreme. Interest rate volatility reached a record low on March 20, 2019, and then exploded. The next five days witnessed a near-record cumulative increase in rate volatility – the fourth highest in the last 30 years and a five-standard-deviation event. 

A slowing economy, weakening manufacturing PMI and a dovish turn from the central banks have all contributed to the rally of global government bonds. The sharp increase in rate volatility over such a short period of time also exposed the fragility in the market structure. Overcrowded positioning, along with low liquidity, drive sharp market moves.

The rate volatility market has undergone heavy selling since the beginning of the year. As a result of the global central banks’ dovish turn, selling volatility has become a natural way to position for rates staying low for the long-term. If the global central banks remain patient, it will be hard for rates to move up or down too much.

However, the low liquidity in the marketplace makes crowded positioning risky. Take E-mini futures, for example. The depth of the order book has come down by 70% since January 2018. This is not a perfect indicator of market liquidity, but it does show how liquidity is deteriorating overall. As J.P. Morgan’s research shows , a small shock can have a much bigger impact on price in a market with lower liquidity. Crowded positioning of volatility shorts and rate shorts needs to unwind in a market with limited liquidity, thus driving a sharp move in rates and the volatility market. Based on past experience, this type of sharp move will usually retrace some in the next several sessions.

In a slower global economy, Treasuries look fairly attractive compared to other government bonds. However, investors should be cautious about the long end of the curve. Modern Monetary Theory (MMT) has garnered significant media attention recently, and although adoption is unlikely, any inclination toward MMT will prove catastrophic for the 30-year Treasury yield. As an absolute-return trade, long-end steepeners may be an attractive option.


Key Takeaway

As demonstrated by the global PMI, the global economy peaked in January 2018 and has slowed down ever since. Interest rates rallied because of slowing economic growth and dovish central banks. Crowded positioning and low liquidity in the market triggered the recent move in interest rates. Long-end steepeners may be an attractive buy, particularly after some rebound from the current low level.


Tags: Manufacturing PMI | Treasury yields | rate volatility

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