One way to understand of the recent market action–one way that makes sense to me–is to think of it as a big short squeeze.
The drop in Treasury yields and the climb in Treasury prices went to far in August with Treasuries showing their biggest monthly gain in the month since the depths of the 2008 financial crisis. Traders moved from pessimistic to excessively pessimistic. At one point in August the market had priced in another 70 basis points in interest rate cuts in 2019.
Now the markets are moving back–not really to optimism so far–but certainly away from extreme pessimism. The market is now looking for about 50 basis points to additional interest rate cuts in 2019. That would be 25 basis points on September 18 and another 25 basis points in December. That’s still the kind of interest rate cuts you get when the Federal Reserve is “concerned” about a slowdown in the economy. But two 25 basis point cuts isn’t anything like the panic that the market had moved to priced in during August.
Yields on the 10-year Treasury are up 12 basis points today to 1.90%from a three year low of 1.43% early in September. The spread between the yields on the 2-year and the 1-year Treasury has widened to 9 basis points. Not a huge vote of confidence in the economy but a considerable improvement on the inverted yield curve we saw a couple of times in August. An inverted yield curve, where the 2-year Treasury is paying more than the 10-year Treasury, is often seen as an indicator of a coming recession.
Now the question is How long does the short squeeze run? The big move up in yields is a limiting factor on a further move in this direction. A yield of 2% or slightly over 2% has been a limit in recent market action. If yields climb much further, the profits in this trade will switch from being long higher yields (and lower bond prices) to being long lower yields (and higher bond prices) again.
The exact moment of the shift depends on economic news and the Fed’s comments after its September 18 meeting on how it sees growth and risk in the global economy.
Unless you see some thing out there in the fundamentals to suggest that growth in the global economy is about to pick up and  believe that the current window dressing in the U.S.-China trade war indicates that a real settlement is near, I’d keep my risk hedges in place. October 1, the 70th anniversary of the founding of the People’s Republic of China is an important date to watch for the reversal of the trend.
