Authored by Simon White, Bloomberg macro strategist,
Short covering on Tuesday drove a powerful rally in Treasuries, but deteriorating liquidity conditions means they face greater downside than upside risk.
The outsized move in bond yields in the US and the rest of the world from a slightly softer-than-expected October inflation print was an unmissable sign of a market that got caught short.
Today’s retail sales number was better than expected (though a decline in headline), potentially wrong-footing the bond market after yesterday’s strong gains.
Leading data continue to be increasingly supportive for retail sales.
As is typically the case when positioning is the primary cause of a market move, the narratives play catch up, with only a 0.1% miss in core CPI largely being used to justify that the Federal Reserve is definitely done hiking, and that they will have to make an extra 25 bps of rate cuts next year. Go figure.
Nonetheless, positioning in bonds is likely now cleaner and more neutral. But that does not alter the deteriorating liquidity conditions in the Treasury and other G7 bond markets. Greater volatility, supply concerns, regulations, etc. are all cited as reasons for declining bond liquidity, but the primary cause in recent years is inflation.
It is the greatest current source of uncertainty. And contrary to the market’s view, there are compelling signs it will re-accelerate next year. Inflation volatility is already rising (blue line in chart below), and it will remain high if and when inflation reheats. As the chart shows, this means bond liquidity will continue to worsen.
Bonds, as their upside potential is limited, typically exhibit negative skew, i.e. they are exposed to greater moves to the downside than the upside. Combined with poor liquidity conditions and receding recession risk, it means investors will be more wary of downside rather than upside risk – starting with the possibility of stronger retail-sales data later today.