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Treasury bulls face rare quandary as stampede stopped in tracks

New York

TREASURY bulls have thrived by following their instincts over the past year. Now's the time for second thoughts.

The past week's sell-off, which drove yields to one-month highs, is a reminder that this US$16 trillion market can still run both ways. And while buying into bouts of weakness has been a winning strategy so far, it's possible that some game-changing developments are afoot.

It's hard to know whether the surge in yields has adequately accounted for the risks from central banks delivering less stimulus than markets want, better news on US-China trade and an unprecedented wave of bond issuance.

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But any attempt to lead the herd out of Treasuries is not for the faint-hearted. Global growth is still faltering, weakness has spread to the US manufacturing sector, and a truce in the tariffs war is still a long way off, by most people's reckoning. Moreover, the Federal Reserve's policy rate looks headed lower.

"With the Fed almost certain to cut rates at this meeting coming up next week, and still certainly plenty of people out there expecting there are more rate cuts to come, at some point a yield near 1.70 per cent looks pretty attractive," said Thomas Simons, senior money market economist at Jefferies LLC.

The rout has driven yields on two- and 10-year Treasuries up to 1.68 per cent and 1.74 per cent, respectively, after both sank to multi-year lows of 1.43 per cent early last week. Those increases have reversed almost half of their August declines.

For investors still committed to the downward trend in global yields, timing is paramount. And it makes sense to sit out some of this week's potential market splashes. Treasury auctions over the next couple of days could push yields around, but the biggest wildcard is probably the European Central Bank's decision on Thursday, which has a lot of moving parts and plenty of room to disappoint markets.

"We are waiting for the ECB," said Mark Holman, chief investment officer at TwentyFour Asset Management. He's concerned that a possible tiered system to reduce the impact of more deeply negative rates for banks could hit German bunds, dragging US yields higher. In the wake of any market turmoil surrounding the ECB actions - or lack thereof - Mr Holman says that he favours the US two-year as a safety trade, based on the prospect of more Fed easing.

At this stage, at least, investors still seem to lack confidence that benchmark yields are in a rising trend after the two- and 10-years plunged more than 125 basis points from their late-2018 peaks. That will take more evidence that the global economy is on the mend, according to Ian Lyngen, head of rates strategy at BMO Capital Markets.

"The extremes of the flight-to-quality sentiment which brought 10s to 1.43 per cent have certainly moderated," he wrote in a note on Wednesday. But that doesn't mean the market has reached the point of "a concerted rethink of the dire prospects for a global recession", he added. BLOOMBERG