Crash Landing

The Narrative tells us the Fed
Will let prices rise up ahead
But if that’s the case
Then how will they pace
The rise in the 2’s-10’s yield spread

And what if this spread keeps expanding
Will stocks markets see a crash landing?
Or will Chairman Jay
Once more save the day
And buy every bond that’s outstanding?

Remember when the Narrative explained that record high traditional valuation measures of the stock market (like P/E or CAPE or P/S) were irrelevant because in today’s world, permanently low interest rates guaranteed by the Fed meant there was no limit for valuations?  That was soooo last month.  Or, remember when economists of all stripes explained that all the slack in the economy created by the government shutdowns meant that inflation wouldn’t reappear for years?  (The Fed continues to push this story aggressively as every member explains there is no reason for them to consider raising rates at any time in the remotely near future.)  This, too, at least in the bond market’s eyes, is ancient history.  So, something is changing in the market’s collective perception of the future, and prices are beginning to reflect this.

The bond market is the appropriate place to begin this conversation as that is where all the action is lately.  For instance, this morning, 10-year Treasury yields have risen another 2.4bps and are trading at their highest level in almost exactly one year, although remain far below longer-term averages.  Meanwhile, 30-year Treasuries have risen even more, and are now yielding 2.155%.  Again, while this is the highest in a bit more than a year, it is also well below longer term averages.  The point is, there seems to be room for yields to run higher.

Something else that gets a lot of press is the shape of the yield curve and its increasing steepness.  Today, the 2yr-10yr spread is 125bps.  This is the steepest it has been since the end of 2016, but nowhere near its record gap of 8.42% back in late 1975.  The Narrative tells us this is the reflation trade, with the bond market anticipating the reopening of the economy combined with a flood of new stimulus money driving business activity higher and prices along with that business.

Now, the question that has yet to be answered is how the Fed will respond to these rising yields.  We are all aware that Federal debt outstanding has been growing rapidly as the Treasury issues all that paper to fund the stimulus packages.  And we have all heard the argument that the size of the debt doesn’t matter because debt service costs have actually fallen over time as interest rates have collapsed with the Fed’s help.  The last part is true, at least over the past several years, where in 2020, it appears Federal debt service amounted to 2.43% of GDP, a decline from both 2018 and 2019, although modestly higher than 2017.  But, if the yield curve continues to steepen as 10yr through 30yr yields continue to rise, as long as the Treasury continues to issue debt in those maturities, the cost to the Federal government is going to rise as well.  The question is, how much can the government afford?  And the answer is, probably not much.  A perfect anecdote is that the increased interest cost of a 50 basis point rise in average Treasury yields will cost the government the same amount as funding the US Navy for a year!  If yields truly begin to rise across the curve, Ms Yellen will have some difficult choices to make.

But this is not just a US phenomenon, it is a global phenomenon.  Yields throughout the developing world are rising pretty rapidly, despite central bank efforts to prevent just that from occurring.  As an example, we can look at Australia, where the RBA has established YCC in the 3yr space, ostensibly capping yields there at 0.10%.  I say ostensibly because as of last night, they were trading at 0.12%.  Now, 2 basis points may not seem like much, but what it shows is that the RBA cannot buy those bonds fast enough to absorb the selling.  And the problem there is it brings into question the RBA’s credibility.  After all, if they promise to keep yields low, and yields rise anyway, what is the value of their promises?  Oh yeah, Aussie 10yr yields jumped 16.9 basis points last night!  It appears that the RBA’s QE program is having some difficulty.

In fact, despite pressure on stocks throughout the world, bond yields are rising sharply.  In other words, the haven status of government bonds is being questioned right now, and thus far, no central bank has provided a satisfactory answer.  Perhaps, the bigger question is, can any central bank provide that answer?  As influential as they are, central banks are not larger than the market writ large, and if investor psychology changes such that bonds are no longer seen as worthwhile investments because those same central banks get their wished for inflation, all financial securities markets could find themselves in some difficult straits.  This is not to imply that a collapse is around the corner, just that the working assumption that the central banks can always save the day may need to be revised at some point.

So, can yields continue to go higher without a more substantive response from the Fed or ECB or BOE or RBA or BOC?  Certainly, all eyes will be on Chairman Powell to see his response.  My view has been the Fed will effectively, if not explicitly, try to cap yields at least out to 10 years.  If I am correct, the dollar should suffer substantially.  Again, this is not to say this is due this morning, just that as this story unfolds, that is the likely trend.

And what else is happening in markets?  Well beyond the bond market declines (Gilts +2.3bps, Treasuries now +4.1bps, even Bunds +0.5bps), European bourses are falling everywhere (DAX -0.6%, CAC -0.5%, FTSE 100 -0.7%) after weakness throughout most of Asia (Hang Seng -1.1%, Shanghai -1.5%, although Nikkei +0.5% was the outlier).  US futures? All red and substantially so, with NASDAQ futures lower by 1.3% although the other indices are not quite as badly off, between -0.5% and -0.7%.

Commodity prices, however, continue to rise, with oil (+1.0%) leading energy mostly higher while both base and precious metals are higher as well.  So, too, are prices of grains rising, as we continue to see the price of ‘stuff’ rise relative to the price of financials.

Finally, turning to the dollar, it is broadly stronger against its EMG counterparts, but more mixed vs. the G10.  In the former, MXN (-1.4%) and ZAR (-1.35%) are leading the way lower, although BRL is called down by more than 2.0% at the opening there.  But the weakness is pervasive in this space with APAC and CE4 currencies also suffering.  However, G10 is a bit different with AUD (+0.2%) leading the way higher on the back of the record high prices in tin and copper alongside the rising rate picture and reduced covid infection rates.  On the flip side, NOK (-0.3%) is the weakest of the bunch, despite oil’s rebound, which appears to be a reaction to strength seen late last week.  In other words, it is market internals, not news, driving the story there.

On the data front we do get a fair amount of new information this week as follows:

Today Leading Indicators 0.4%
Tuesday Case Shiller House Prices 9.90%
Consumer Confidence 90.0
Wednesday New Home Sales 855K
Thursday Durable Goods 1.0%
-ex transport 0.7%
Initial Claims 830K
Continuing Claims 4.42M
GDP Q4 4.2%
Friday Personal Income 9.5%
Personal Spending 2.5%
PCE Core 0.1% (1.4% Y/Y)
Chicago PMI 61.0
Michigan Sentiment 76.5

Source: Bloomberg

Beyond the data, with GDP and Personal Spending likely the keys, we hear from a number of Fed speakers, most importantly from Chairman Powell tomorrow and Wednesday as he testifies before the Senate Banking Committee and then the House Financial Services Committee.  The one thing about which you can be sure is that Congress will ask him to support their stimulus plan and that he will definitely do so.  It strikes me that will just push Treasury yields higher.  In fact, perhaps the March FOMC meeting is starting to shape up as a really important one, as the question of higher yields may need to be addressed directly.  We shall see.

For now, yield rises are outstripping inflation prints and so real yields are rising as well.  This is supporting the dollar and will undermine strength in some securities markets.  However, history has shown that the Fed is unlikely to allow real yields to rise too far before responding.  For now, the dollar remains in its trading range and is likely to stay there.  But as the year progresses, I continue to see the Fed stopping yields and the dollar falling accordingly.

Good luck and stay safe
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