Before Powell stepped to the mike
The buyers of bonds went on strike
Then Jay warned again
Inflation is when
Both prices and yields tend to spike

Investors absorbed this new news,
(The bond market fail and Jay’s cues)
And offloaded risk
In manner quite brisk
So, that’s why we’re singin’ the blues

Remember when I explained that some weeks are just really slow?  Just kidding!  The remarkable thing about financial markets is one most always be alert to a shift in sentiment, even if it doesn’t make that much sense.  However, yesterday’s shift made sense.

Last week when the QRA was published, the market took the news that a much larger percentage of issuance in the coming two quarters would be T-bills and not notes or bonds as a huge positive.  We saw a significant rally in the bond market with 10-year Treasury yields falling nearly 50bps and we saw a corresponding rally in the equity markets as the major indices rose nearly 5%.  Everybody was happy and the narrative was the worst was over for the risk asset correction.  Oops!

This week has been the Treasury auction week, when they issue the newest tranches of 3yr, 10yr and 30yr notes and bonds.  On Tuesday, the 3yr went fine.  On Wednesday, the 10yr was acceptable, if a little weak, but given the broader narrative of positivity, it had limited impact.  Alas, yesterday, the 30yr was an unmitigated disaster.  

The two key statistics that are followed in this relatively arcane part of the markets are the tail (the difference between the final yield and the lowest bid accepted) and the bid-to-cover (BTC) ratio which describes the total amount of bids compared to the issue on offer.  Typical tails are in the 0.5bp – 1.5bp range.  Yesterday saw a 5.3bp tail, the largest ever, with the implication that they had to go through many bids to fill in the auction.  The BTC yesterday was 2.24, far below the 2.38 average of the past ten auctions, and another indication that investors are not that interested in owning long duration Treasury paper.  In fact, dealers (mostly banks) had to absorb almost 40% of the issue, double the usual amount.  This is another indication that there aren’t many natural buyers of this paper right now.

In the wake of this auction, we saw bond yields rise sharply, up 11bps from the open, through the auction and then afterwards until the time that Chairman Powell spoke.  Now, while Powell didn’t actually throw more gasoline on this fire, he certainly stoked it.  Speaking at an IMF conference, he opened his comments with the following (emphasis added), “The Federal Open Market Committee (FOMC) is committed to achieving a stance of monetary policy that is sufficiently restrictive to bring inflation down to 2 percent over time; we are not confident that we have achieved such a stance.”  A bit later he made sure to remind us, “If it becomes appropriate to tighten policy further, we will not hesitate to do so.  We will keep at it until the job is done.”  

Needless to say, risk assets did not perform well yesterday or overnight (US indices fell between -0.65% and -0.95%, Asian indices fell as much as -1.75% and European bourses are all lower by about -1.0% this morning) as investors dreams of rainbows and unicorns came crashing into the reality of the idea that interest rates are not going to be declining anytime soon.  Not only is it unlikely that the Fed is going to reverse course, but yesterday was the first concrete indication that the cost of funding the US budget deficit may be starting to become a problem.  (In fairness, it has been a problem all year and pointed out as such by numerous pundits, but yesterday the market, as a whole, seemed to get the message.)  This is a major crimp in the narrative that just got developed last week.  

Recall, the view that had come out of the Fed’s allegedly dovish stance and the weaker than expected NFP report was the Fed was done, inflation was going to fall, and yields would be heading lower across the curve. The unspoken part of that narrative was that there would be plenty of demand for Treasury paper because both investors and traders would be jumping in to get ahead of the decline in yields.  Apparently, this feature of the narrative will need to be restructured, and with it, potentially, the entire narrative.  This process is going to be the major market driver over the coming months and quarters.  If the Fed maintains its higher for longer stance, and more importantly, continues along the QT path, shrinking its balance sheet, they will achieve the reduction in demand they currently seek to bring things into balance.  Unfortunately, given the Fed’s inability to fine-tune this process, things have the chance to get very messy on the downside.

Summing up, the bullish narrative took a major hit yesterday and we will need to see a perfect combination of gently slowing economic data alongside quickly slowing inflation data to resurrect it.  Personally, I would take the under on that bet.  In fact, I fear that we could well see a much more rapid decline in economic data, with a recession on tap for early 2024 along with still sticky inflation keeping the Fed firmly wedged between that rock and that hard place.  In this scenario, risk assets are very likely to underperform substantially.  A key to watch will be the shape of the US yield curve.  If (when) the bear steepening reasserts itself and long-term yields rise above the front end of the curve, you can be sure that a recession will be right around the corner.  Sic semper erat, et sic semper erit.  (Look it up)

Ok, well after that distressing discussion, a quick look at how other markets have behaved shows the following.  Treasuries have edged lower by 2bps this morning, but that was after yesterday’s 14bp rally.  European sovereigns, though, were closed when all the fun happened and so are catching up with yields higher by 6bps-7bps across the board.  Not surprisingly, JGBs are little changed, but then there is no indication that the BOJ is going to stop QE anytime soon.

On the commodity front, oil (+1.5%) seems like it is finding a floor after its recent sharp decline, although given its inherent volatility (both literal and financial) I’m not confident the bottom is in.  There has been much talk of significant speculative selling as a key driver of this move, but regardless of why, I would be wary of much signal from its price movement right now.  Meanwhile, gold (-0.6%) which rallied sharply yesterday is in the process of giving it all back and base metals remain under general pressure. 

Finally, the dollar is mixed this morning with both gainers and losers across the G10 and EMG blocs.  In truth, the G10 movement has been quite limited, +/- 0.2% or less with one exception, NOK (+0.8%) which is benefitting from higher-than-expected CPI data and the belief that Norgesbank is going to be tighter going forward.  In the EMG bloc, the movements have been a bit larger, 0.3% – 0.5%, but we are also seeing a mix of directions with, for example, MXN weaker while PLN is stronger.  Net, I would say there is not much new here (the dollar did rally yesterday in the wake of the higher US yields) and I expect that traders will be happy to go home square this weekend.

On the data front, this morning brings the Michigan Consumer Sentiment (exp 63.7) and, remarkably, even more Fed speakers with Logan and Bostic on the calendar.  At this point in time, I suspect that both traders and investors are going to be re-evaluating their medium- and long-term views on the progression of both economic activity and inflation.  The bullishness of last week’s narrative has clearly been called into question.  Arguably, we are going to need to see a lot more data to help convince market participants of the next trend.  Next Tuesday starts with CPI data where a hot print will likely be seen quite negatively as it will push any Fed ease further into the future.  But today does not seem like a session where much more will happen.  In the end, as long as the Fed remains the most hawkish, and after yesterday I think that was reinforced, the dollar should find support.

Good luck and good weekend

Adf