The bond market is raising red flags about a trade deal, while stocks largely ignore it

Patrik Stollarz | AFP | Getty Images
U.S. President Donald Trump and Chinese President Xi Jinping at the G-20 summit in Hamburg, Germany, on July 7, 2017.

A quick reversal in the bond market shows how easily investors can be spooked by doubts about a trade deal, and what it might mean if one does not materialize.

Optimism for a phase one trade deal had helped drive yields higher, with the 10-year yield gaining more than 20 basis points last week to a high of 1.97% by Friday.

But on Tuesday President Donald Trump reported no new signs of progress and said he could issue new tariffs if there's no deal, deflating some of the expectations for an agreement. Trump was speaking to the Economic Club of New York.

There were also reports that the two sides remain far apart on China's demand for a rollback in tariffs, and on Wednesday afternoon the Wall Street Journal reported that China is balking on putting a specific dollar figure on the amount of agricultural products it would buy. On Thursday, a spokesman for China's Ministry of Commerce told reporters that China is still calling for the U.S. to roll back tariffs as part of the phase one agreement.

By Thursday morning, the 10-year yield had fallen to 1.83%, after sliding six basis points on Wednesday from Tuesday's close of 1.92%. The Dow and S&P 500 were slightly higher Wednesday and closed at record highs. On Thursday, stocks were set to open slightly lower.

"Bonds trade more like stocks these days" in terms of their volatility, said Peter Boockvar, chief investment officer at Bleakley Advisory Group. "We got to almost 2% in a rather short period of time. The drop in yields is just back to where we were in the middle of last week. It's being driven by what's going on in yields overseas. You're seeing a 5 basis point decline in the German 10-year ... People are worried about this trade deal and what the substance of it is."

Besides Trump's comments, protests in Hong Kong are casting doubt on a deal. Investors worry that China and the U.S. will have a hard time agreeing on a trade pact with the Senate moving toward a vote on a bill supporting pro-Democracy protesters in Hong Kong.

"A lot of the move we saw last week was trade optimism. If that trade optimism is unfounded, it makes some sense you take some of that optimism out," said Jon Hill, fixed income strategist at BMO. Strategists continue to expect a deal, and it is expected before new tariffs go into effect Dec. 15.

Investors have been expecting to hear about a location and date for a deal signing between Trump and China President Xi Jinping, but so far no meeting has been announced. Instead, reports have surfaced that the two sides are in disagreement over China's desire to see existing tariffs lifted.

"It really is trade driving the bus for us," said Michael Schumacher, a strategist at Wells Fargo.

The bond market has become somewhat more volatile than it normally is, and now strategists expect to see the 10-year trade between 1.75% and just over 2%. Strategists say 1.90% was an area of technical support in the 10-year, and the yield fell harder Wednesday when it moved below that level.

"I would say if trade goes very well, and there's some immediate resolution, the 10-year could hit 2.25" by spring, Schumacher said. "We're talking about Trump and Xi shaking hands and actually signing something. You can think about a range of trade agreements. Removing tariffs that are in place would be a very large move to us."

Goldman Sachs strategists see scope for a higher 10-year yield but how high depends on the type of trade deal. Increases will also be curbed by the fact central banks are unlikely to raise interest rates.

"Our analysis suggests that 10y Treasuries will struggle to move sustainably above 2.2% (and above 2% without tariff rollbacks), largely on account of policy expectations having reset lower over the past year, and central banks signaling a high threshold for future changes," the Goldman strategists wrote.

Some strategists have said yields are in an uptrend. "Our positioning metrics suggest risk of a near term selloff — this is particularly likely on positive catalysts, such as tariff rollbacks. Other risks include spillovers from a strong environment outside the US. However, we would view large selloffs driven by either of these factors as a tactical opportunity to set longs," the Goldman strategists noted.

Schumacher said the market is so far ignoring impeachment hearings against Trump, and Fed Chairman Jerome Powell testimony offered nothing new when he spoke Wednesday.

As rates rose last week, stocks that benefit from higher yield and better growth gained.

"There's been a lot of faith in a soft landing," said John Briggs, head of strategy at NatWest Markets. "We were in a recession in October and now we're in a perfectly executed soft landing and everything is great." But Briggs said investors should be wary. "We're heading into an election year with trade issues are still out there."

Briggs said he does not see an uptrend in yields and sees the 1.75% to 2% zone on the 10-year yield as a "buy the dip zone."

As yields rose last week, the yield curve steepened, which was opposite the inversion in yields that occurred when investors were worried about trade wars in the summer. The inverted curve means a shorter duration yield, like that of the 2-year note, was rising above yields at the long end, such as the 10-year.

An inverted curve is seen as sign a recession could be in the offing, so as the curve steepened, the stock market responded positively, reaching new highs.

"The economic data is getting better. There supposedly is a phase on trade deal coming. It does run the risk of a boy who cried wolf dynamic, if you consistently get indications a trade deal is soon and it doesn't actually occur. That eventually diminishes credibility," Hill said.

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