The economy is on the mend, the going has been easy with the Fed pumping massive stimulus only to be outdone by the passing of the massive $1.9trn + stimulus bill. This is the perfect storm. Markets are close to all-time highs, but bonds are still freaking out.
In fact its only been 2 weeks since I wrote this piece:
Yield Breakout and ‘Shadow rates’ – Moe-Knows (moe-knows.com)
Where we outlined WHY the rise in the bond yield may cause markets to be a little spooked. The intent of today’s article is to opine on what the status quo looks like and its implications.
Since the blog post 2 weeks ago, yields have continued to rise by over 20 bps. Not to get too complex for those who don’t follow bonds, but there is a quirk called convexity. Despite the fancy word, all it means is that bonds with a longer duration tend to react more negatively in price to changes in interest rates.
It is not a linear relationship. That means that for a step shift in policy rates for example, a 30 year bond would lose more value than a 10 year bond and so forth.
A quick glance at the two charts below look like the same move. The one on the top is the US 10 year yield and the bottom is the US 30 year yield. Both have risen, at a cursory glance, in tandem. Both are at the highest levels in a year with the 10 year now at 1.62% and the 30 year at 2.38%.
However, when looking at the spread or difference between the two, as show in the chart below, it is apparent that 30 year yields started moving higher in relative terms since September 2019 but are more or less flat for the year to date. What does this mean?
To me, it shows that while the move in absolute yields has been remarkable for the year to date, that the entire curve has moved in league implying that the expectation is not one of ‘runaway inflation’ rather than a short term policy response from the Fed.
The March meeting
The Fed meeting concludes today and by 2pm ET, we will know what the wizened Fed governors believe the current status quo and policy path will be. The market is looking for some new guidance from the Fed in terms of its thinking and when it believes we could see a withdrawal of monetary stimulus, possibly by 2023. They will also release new economic and interest rate forecasts.
Bear in mind that the Fed’s primary policy tools are not only the level of interest rates, but also the level of asset purchases. At present, the Fed is buying around $80bn of Treasuries a month and $40bn of mortgage securities.
The Fed has been clear that they will provide plenty of time between communicating and acting. Not only is the market looking for guidance in terms of when the Fed may consider higher rates, but also what they will do with the asset purchase program. They will likely be reticent regarding tightening too quickly amid early signs of a post pandemic recovery.
Could we see a resumption of Operation ‘Twist’ which will see the Fed by supporting longer dated securities to keep long end yields anchored while allowing shorter dated yields to move higher. Bear in mind that the long end (30 year) is also where mortgages are benchmarked, so by supporting this point, they could alleviate any pressure on the housing market and consumer balance sheets.
Fed Chair Powell is likely damned if he does and damned if he doesn’t. Markets are forward looking and may well price any future indications for the eventuality of tighter policy, immediately.
If he doesn’t move on policy tightening, it may well be seen as incongruous with the Fed’s own estimations of an economy undergoing a rebound and could be seen as negative for the economic outlook over the longer term. If he does move, bond bears will feel vindicated, but the higher yields will continue to spook the markets.
These are all symptoms of a market which is looking quite stretched and as such is hyper sensitive to the moves of policy makers. A market which for too long, has come to rely on the ‘Fed put’. All it does is expose further cracks in an already stretched system.
We’re all going Dotty
Around 10 years ago, when I first presented on the Fed ‘Dot Plot’ to a series of institutional investors in South Africa, it was a relatively unknown concept and I was set on explaining what it was and why it was or wasn’t important to framing expectations. Today, many are familiar with its usefulness or relevance to their own frameworks.
Simply put, the Fed Dot Plot (below) is a quarterly indication of where respective Fed members see interest rates in the respective time periods. It is anonymous so as to remove any fear of gerrymandering among participants. While useful as an indicator to provide context to Fed speeches and commentary, it has also been notoriously unreliable over time.
I recall prior to the last phase of tightening, how the Dots showed a much more aggressive tightening cycle than what transpired, and the dots inevitably ‘evolved’ to catch up to the market. The last update in December showed a fairly flat profile and the Dots to be release this week may well show a more aggressive tightening cycle coming.
At present, the Fed funds futures (the market) are pricing 1 hike in 2022 and 3 hikes in 2023. An already aggressive expectation. As such, if the Fed profile is softer, we may see some reprieve to short term pressure on bonds.
However, we must look beyond the immediate short term reactions to the longer term prognosis for the economy and the markets.
What does Mr. Market say?
The current market positioning indicates a hypothesis that the massive stimulus programs will create a spike in demand that will drive inflation which in turn will drive interest rates higher.
But inflation is a rate of change and as such, as base effects (a higher price base) gets baked into the data over the long term, inflation rates tend to taper off unless there is real sustained underlying demand / supply mismatch.
Despite periods of runaway inflation in developing countries, developed economies have not seen runaway inflation in a generation. Inflation is a slow-moving variable in the first world. This is because there is a wage/price feedback loop. Wages are set based on inflation expectations.
Inflation expectations for long run inflation have been less spectacular. According to the Cleveland Fed. 10-year inflation expectations rose from 1.38% in January to 1.48 currently. This is a long way off from what the market is fearing and ties in with the comments above regarding the 30/10 year spread.
It signifies that there is still some semblance of credibility being placed in central banks to ensure that inflation is kept in check in the long run despite permitting short term overruns. This signifies why central banks are so concerned with ensuring that inflation expectations are kept in check and the use of forward guidance (or jawboning) has become a policy tool in and of itself.
Moral suasion as well as highlighting the credibility of an independent central bank are critical elements. If this tool is to retain its efficacy, central banks are going to have to act sooner or later and this may come with short term consequences. However, in the longer term, we are all probably better off. If they fail to act, they will paint themselves further into a corner and exacerbate potential systemic risks with potentially even greater consequences later.
In the short run, inflation is not the bogeyman. Global inflation remains low and can be contained. The current boogeyman is the pandemic and what the recovery looks like amid fears of a 3rd wave. The world is in recovery mode and will be for some time.
That said, keeping an eye on the inflation boogeyman is probably a smart strategy. I am certainly not one to advocate for central banks keeping the punchbowl at the party when everyone is drunk already, but perhaps a few more drinks wouldn’t hurt while we all try to find our designated driver.
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