Weekend Market Brief – Sunday 9/23/18

China announced Saturday morning that they are cancelling the upcoming trade talks. Previously China proposed to send two mid-level delegations to the United States in hopes to ease trade tensions. China also stated that talks may resume sometime after the U.S. midterm elections in November.

With Treasury yields jumping back to their recent highs, there are renewed expectations of yields breaking out to the upside. Quantitative Easing caused short-term interest rates to fall and long-term interest rates to rise, which is easily seen by charting 10-year Treasury yields against the Fed’s balance sheet.

As the Fed unwinds their balance sheet, which is Quantitative Tightening, short-term yields should rise, and long-term yields should fall. So far, both short- and long-term yields have been rising. The reason long-term yields have been rising is due to the largest speculative short interest on long-term Treasury bonds in history.

Back in May 2018, both 10- and 30-year Treasury yields revisited their recent highs. Since then, yields fell, then rose back to revisit their May highs. While most investors are seeing this recent move as a sign yields are about to break out to the upside, it’s worth examining the speculative positioning.

Since May, short interest on 10-year Treasury yields have increased by +75% and yields did not breakout past their prior high. Short interest on 30-year Treasury yields have increased by +250% over the same period, and yields did not breakout past their prior high.

It’s very clear the Fed’s balance sheet unwind is causing long-term bond yields to fall, which is the natural course yields should take during periods of monetary tightening. Yields fall during periods of monetary tightening to offset the reduced growth rate of the money supply.

Speculators have continued to aggressively increase their short positioning because they believe Treasury yields should be skyrocketing. If all the speculative positioning was removed, both long and short, Treasury yields would be falling. With the Fed expected to raise the Federal Funds rate by 0.25% on Wednesday, which is a form of tightening, unwind $33 billion from its balance sheet next week and increase its balance sheet unwind to $50 billion per month starting in October, it will continue to put downward pressure on Treasury yields.

At some point, the speculators will be forced to exit their short positions, which should lead to a massive short-squeeze in the Treasury bond market. The end result should be considerably lower Treasury yields and higher Treasury bond prices.