Bonds continue to rally against the odds

Against the odds, 10-year US treasuries have moved back below 2.5%, to be at the lowest levels since markets began their taper tantrum.

The data in the US has been mixed since the start of the year.  Labour market indicators have been decent, with payrolls solid and jobless claims falling. Leading indicators like the ISM indices have been solid, although at lower levels than end-2013.

However, some key areas have been patchier than anticipated. Housing market activity in particular has been weak, notwithstanding the impact of weather.  Q1 GDP also looks like it will be significantly negative rather than flat.

Very recently, poor data in Europe and the high likelihood of ECB action next month has also helped drive bond yields lower.  GDP in Q1 disappointed, while manufacturing has failed to fire despite better PMI data.

The yield curve has flattened a little further over the last few days as bonds have rallied, although not dramatically so.  The 2-5yr spread is still much steeper than the last time 10yr bonds were below 2.5%.

Its interesting that against this backdrop of soggy data and rallying bonds at the longer end of the curve, inflation expectations derived from 5 year TIPs have actually risen to a touch under 2%. This is notably higher than the last 12 months or so.

It's also interesting that while bonds have rallied, gold has been much more meek. This wouldn't be the first time in the last 18 months that gold and real interest rates have diverged, with previous periods providing interesting signals for expectations on monetary policy.

So what does this all mean? There does seem to be an opportunity in the mixed signals from the yield curve and inflation expectations.  It doesn't make much sense that inflation expectations are creeping higher as 10yrs are rallying on weaker data.

It also would appear that gold and bonds are currently telling us something different about FOMC expectations, as they have done in the past.  Although this time around, the picture maybe a little more complicated given the potential impact of ECB action on FX markets.

This seems unlikely to spark the long gold/short euro trade that worked wonders back in early 2010, so if ECB action means a stronger USD, then that is probably weighing on the attractiveness of gold, even if real interest rates are falling.