On Thursday, the European Central Bank (ECB) announced ... nothing. No cut to its already-negative interest rate target. No expansion or other modification to its already humongous asset purchase (or QE) program. In response, U.S. bonds took a dive, especially long-term bonds. If you had any doubt that the U.S. bond market is now under control of Europeans, Thursday's market should have removed it.
So what do I mean by that? I am not a day trader professionally. I manage long-term bond money for mostly institutions. But even investors with longer-time horizons should understand that all decisions (by all players) are made in the moment. So, whenever any market is rallying or selling off, it is a window into the reaction function of other investors. Or put another way, there are various ways to justify a given valuation for any financial instrument. Only by observing how others revalue that security in response to incoming data can you determine what goes into their valuation calculation.
As I have said in this space many, many times, the most important thing in investing is understanding what is priced into the market. You cannot divine what is priced in merely by breaking down the security's price into its components. You have to see how those components change day by day.
So, what did this ECB announcement tell us about the U.S. Treasury market? First of all, we know people expected the ECB to expand its QE program in some dimension. It did not. In addition, ECB President Mario Draghi said that they were going to be patient, giving their existing programs some time to see how they impact the European economy. The market seemed to read this as not only are they giving no additional stimulus now, there was no guarantee they'd be giving us more stimulus anytime real soon.
Core EU bonds (e.g. Germany) sold off hard on the news in a steepening fashion. That is to say, shorter-term bonds hardly moved, while long-term bond yields rose significantly. U.S. Treasury bonds followed suit almost exactly, selling off only to a slightly lesser degree than Germany.
The fact that German bonds and U.S. bonds basically performed the same despite the fact that the former is directly impacted by ECB policy while the latter is not, is telling. It means that the marginal buyer of U.S. bonds is someone deciding between U.S. and core EU bonds. This is Microeconomics 101. The price is being set by the price of substitutes and we know that because the good in question is moving in price right along with the price of a substitute. So, U.S. bonds are behaving exactly like the price of gasoline at two stations across the street from each other. The prices at the two stations almost have to move in lock step because customers view them as substitutes.
So, that's what the market thinks. But is it right? A steepening yield curve implies that short-term rates are unlikely to change soon, but in the intermediate-to-long term, the central bank is likely to remove accommodation and/or inflation will pick up.
Let's play through on the logic of what Draghi said. We know the ECB is badly missing the inflation target to the downside. There really isn't any evidence that inflation is picking up. It isn't ridiculous to give the current programs a little more time before judging, but there isn't any objective evidence that the programs are "working" and might be curtailed anytime soon. I don't know if Draghi believes that they have done enough or is just wildly optimistic. But if so, this optimism is based on nothing other than blind hope.
The alternative is that Draghi is starting to doubt QE's effectiveness. The truth is that the ECB is on an unsustainable path with the current program. Unless supply of corporate bonds issued in euros picks up in a big way, the ECB will run out of bonds to buy. There are some things they can do on the margins to buy more time (so that they can buy more assets), but that too will run out before too long. With the ECB missing the target so badly, it seems highly likely to me that it will be forced to try something else before too long.
What is that something else? Helicopter money? Buy equities? Who knows? But if, indeed, the only reason why they are slowing down on QE is because they are going to run out of bonds, that hardly sounds bond bearish to me. Or if they are just unwilling to go to anything more creative than their current programs, it implies an even longer period of near-zero short-term rates -- also not bond bearish.
Now, we are reaching some important technical levels on U.S. bonds, so we could be in for some choppiness. But intermediate term, I think once the smoke clears, you will be glad you bought bonds at this levels. I'm adding duration here.