Goodbye to Credit Writedowns

Good morning everyone, 

I have some exciting — and also - sad news to tell you today. 

First, I am going to Bloomberg as a Senior Editor. And I am going to use that (much larger) platform to share my views on the macro economy and financial markets. I am really excited about it too. It’s a great team of people I am joining and so many resources to help me write good market and economic analysis. So that’s the good news, the really good news!

The sad news is that, as a part of that move — and after thirteen wonderful years writing Credit Writedowns — I am putting the site on hiatus.  I just checked the site’s back end and it shows me having written nearly 8,000 posts in that 13 year period. Wow. My first post back in March 2008 was the one where I boldly proclaimed “The Economy Is Definitely In Recession”. 

You may not know this but I started this site as a ‘hobby’ to recuperate after contracting Lyme Disease. I though it would be cool to put my thoughts to paper because it would help tease out what I was thinking about the macro outlook given the financial crisis that was brewing at the time. Then, a week later, Bear Stearns collapsed and I kept on writing and never looked back. It’s been a wild ride since then. 

Now, don’t give up on me just because I won’t be posting here. You can follow along with my writing at Bloomberg. Now, a lot of what I write will be for the Bloomberg Terminal audience. But I will also have the opportunity to write for the Bloomberg website and potentially Bloomberg Business Week as well. 

For those of you who are now or have been paying subscribers to the newsletter I started over 9 years ago, I want to say thank you for your support. Thank you for helping me do something I love and feel passionate about. I am humbled by the encouragement you have given me over the years. Your support has changed my life.

That’s about it for today. If you’re on a year’s subscription, expect a pro-rata refund since I am stopping. And for everyone, if you have any questions or comments, please shoot me an email at edh at creditwritedowns dot com.

I’ll see you over at Bloomberg.

Ed

A note to readers: Edward Harrison is joining Bloomberg Media starting next week. You can find out more about Bloomberg's information practices by reviewing their privacy policy here. And if you no longer want to receive this newsletter or be on its mailing list, you can unsubscribe by clicking the “Unsubscribe” link at the bottom of this email.

Risks to growth and inflation helping keep long rates down

As I write this, the US 10-year Treasury bond is yielding 1.457%, well under the trading range it had established during this quarter. And there are a lot of theories as to why this is happening. I want to spell out how I'm thinking about the yields and what the risks and opportunities are going forward.

So let me start with what the Fed can and cannot do to influence that rate and move from there to market participants and the outlook for real economy as the three main determinants. 

The Federal Reserve's role

Because of the Federal Reserve's role as a monopoly supplier of reserves, it sets overnight rates with an iron fist. All of the discussion around interest on reserves and reverse repos is noise regarding how to best enforce its monopoly power in a world awash in excess reserves. But the macro picture is one where the Fed dictates the overnight rate and the market moves to that rate now and in the future. The same is true in Canada, New Zealand, the Eurozone, Japan and elsewhere in the developed world.

But as we move to out the curve, the Fed cannot control rates with an iron fist unless it actively intervenes in the market. It can influence rates by telegraphing forward policy guidance. It can even buy Treasury securities, adding to demand for those assets. But the Fed can't dictate rates unless it actively engages in some form of yield curve control, something it is not willing to do. The result is that, while the Fed can influence longer-term interest rates, it cannot control them. And so, the term structure of Treasury rates, to a large degree, represents the market's collective wisdom about future Fed overnight policy.

Right now, we are in the midst of a mooted policy paradigm shift where the Fed prioritizes employment over inflation. And so, after the market's apparent disbelief in Q1 2021 regarding the Fed's willingness to let the economy 'run hot', market's have capitulated and temporarily accepted the Fed's forward guidance and newfound religion on employment as a primary mandate.

The market's role

This is a messy process, however.

For example, take a look at the following chart from John Authers. I called it the chart of the day on Twitter yesterday.

The rate trend channel begun after the 2020 re-opening might still get us near 2% by year-end. But, the line kinks upward abruptly and become unmoored from Trend in Q1 as inflation expectations increased. This was the market frontrunning future Fed policy tightening. But that fromntrunning was an overshoot.

So, the Authers chart is making the case for thinking of Q1 2021 as putting Treasuries in an oversold position that we are now unwinding. And so we are heading back to trend. And we could well overshoot to the downside in so doing. Again, markets are messy and chaotic in the short run, but the best predictors we have in the long run.

But what if the downdraft in yields is not merely an overshoot but a fundamental change in the frontrun of rates? Take a look at this chart from Bloomberg's Sebastian Boyd.

He says the "gradual decline in breakeven inflations, and the widening spread between the two- and five-year measures suggest there's no urgent need for the Fed to start tapering talk." And clearly, if the Fed isn't going to even begin to talk about unwinding accommodation, then they aren't going raise rates anytime soon. Markets expectation of the Fed's rate hike timetable has to shift outward and rates fall as a result.

I think both of those factors could be at play here. At a minimum, the move below 1.50% on the US 10-year breaks any momentum to the upside, as we are now below both the 50- and 100-day moving averages, with the 200-day all the way down to 1.16%.

The real economy

But ultimately all of this is predicated on the real economy, fiscal policy and the Fed's reaction function. And having just spoken to Warren Mosler, founder of Valance and godfather of Modern Monetary Theory, I do wonder whether the real economy will have enough momentum to sustain higher rates. Let me explain why.

First, when it comes to fiscal and monetary policy, we should think of monetary policy having a direct impact on the real economy only through the interest income channel by providing interest income to the private sector since the government is a net payor of interest. That means that schemes like quantitative easing which involve a swap of interest bearing assets for reserves are net destroyers of private sector interest income, which also means their primary impulse is contractionary. It also means that the real economy primary impact of zero or negative rates is contractionary as it means less interest income for the private sector, again because government is a net payor of interest.

So, to the degree so-called accommodative monetary policy has any stimulative real economy impact, it is in goosing asset prices by moving investors into riskier, higher duration and higher yielding assets and by favoring debtors over lenders. The hope is that debtors will spend and invest more than lenders would. I would say that's small beer, especially as compared to the contractionary impulse of robbing the private sector of interest income.

So we have to turn, second, to fiscal policy. And there, the wrangling in the US over private sector income support makes it clear that we risk a downshift in how much government transfers to the private sector as pandemic-related support is dialed back without necessarily any longer-term infrastructure or other spending to replace it. If you add the reduction in fiscal deficits to a continued loss of interest income, you have the makings of a potential slowing, a continued yield curve flattening and a greater loss of interest income.

And let's remember, since everyone still thinks the Fed's reaction function goes from higher inflation to higher rates and the concern now is inflation, the pain trade is still lower yields. And convexity will force duration-matching investors to buy in large measure if that pain trade crystallizes, resulting in a potential big move down in yields as shorts cover.

My view

I'll be honest I think Warren is right about the primary impulse of rates coming via the interest income channel, which means the Fed has their policy choice somewhat backwards. To the degree inflation does move the Fed into action, it would cause them to send tightening forward guidance signals and help move long rates up, which would add interest income to the private sector and potentially accelerate any inflationary impulses, causing the Fed to 'tighten' even more aggressively.

That's a 'crash up, crash down scenario' where yields rise to the point where Ponzi borrowers and some speculative borrowers are brought to heel, causing economic momentum to move into reverse and interest rates to crash down. 'Crash up, crash down' destroys risk-on assets on the way up and then lards up the system with NPLs on the crash down. It's a risk that should give policymakers sleepless nights.

Right now, markets are moving the other way though, with yields below the 100-day moving average. But I think bond vigilantes are simply licking their wounds and waiting for more negative inflation prints to move the Fed's forward guidance. Just maybe, the Fed will react. Just maybe the Fed's newfound employment emphasis is not as firm as it might seem. It's around Jackson Hole that we'll find out.

What's your model on how real GDP grows durably?

Quick note here to follow up on the macro crystal ball post I wrote a couple of weeks ago (link here for subs).  Michael Msika over at Bloomberg had a piece out on the return of capex powering the next rally. And for me it connected a lot of dots. Let me outline my thinking below.

What I wrote in the macro crystal ball piece was this:

there is a sequencing that I am looking for though. The sequence goes from consumers’ wages to consumption to industrial production to capital spending and corporate profits. That means wages should be key to the strength and durability of a recovery. While employment and capital spending are lagging indicators, rather than drivers of the business cycle.

So, in the wake of massive government transfers that have kept household balance sheets intact, we can look to employment trends to judge whether this cycle has legs. In Europe, employment schemes like Germany's Kurzarbeit framework combine with the boost from government transfers to mean the first leg of the sequence from wages has been shored up. In the US, we are seeing lots of wage gains as the re-opening proceeds. Yesterday, I saw that Bob Burgess picked up on this and connected it to the potential for capex gains.

Is this the makings of a wage-price spiral or a one-time step change from poverty wages to a livable income?

I believe we're seeing the latter. If so, it means a secular shift higher in consumption, giving companies reasons to invest instead of doing buybacks https://t.co/JTWt9YWlbt

— Edward Harrison (@edwardnh) June 9, 2021

Later I saw the Msika piece on the Bloomberg Markets Live blog, where he wrote about Europe:

Companies are ramping up spending in the post-pandemic world, increasingly favoring investments and expansion over returning money to shareholders. That's likely to boost economic growth but also create stock market winners.

On point. Here's the best chart he used.

He's saying exactly what I was saying: when you see large segments of your clientele with cash to spend and wage growth that means they will be able to spend more into the future since wages are sticky, you will want to invest in the future. Companies on both sides of the Atlantic are seeing that at the moment. And that means there is greater prospect of a durable non-secular stagnation upturn.

And to piggyback on what Msika is saying about Europe, remember this chart. I posted it in May.

It's telling you there is room to run in Europe. And as Msika says, there will be stock market winners. He sees capital goods, oil services, technology, materials and carmakers with commercial units benefitting. That's something to watch as Europe plays catchup to the US.

Do inflation expectations even matter anymore?

We got a big CPI print today, 5.0%. That's above expectations. And, we saw a mild uptick in US Treasury bond yields on the back of the number. But I am wondering whether it really matters. Let me explain.

Yesterday, after posting on the death of the so-called bond vigilantes, I was talking to my friend J. And I told her that, back in February, I had been writing about my concerns regarding inflation expectations becoming unanchored.  In our conversation, I referred to these comments:

this [rise in yields] is the market frontrunning the Fed based on expectations about real GDP growth or inflation or both. The market is essentially signalling concerns that nominal GDP is going higher and that yields need to move in that direction to either protect against inflation or because the Fed will act with a lag.

... I am more concerned about inflation this time than I was last time [in 2018]. I don't think it is a secular issue, but it could be a cyclical one. With commodity prices rising and pent-up demand potentially buoying prices further still once enough people are vaccinated, we could see an even steeper sell off in bonds as inflation expectations rise. I remember being less concerned about that in 2018.

I remember her response being something to the effect: "Does it matter, Ed? At this point, the Fed is signalling it is going to look through inflation and focus on employment. So I'm not sure it does."

That's where I am too. Yes, we got a mild uptick in yields on the back of a bad inflation print. But bond markets are telling you they don't think the Fed's reaction-function is as inflation-dependent anymore. We're in a new policy regime. And that matters for rates.

While I continue to believe we will see yield flares in the back half of the year if inflation prints continue to be hot, the pain trade is in the opposite direction, toward lower yields and higher convexity on bad economic data.

That's one of three outcomes. Another is where an increasing number of people are positioning. You've heard Larry Summers and Stephen Roach voice their concerns about the Fed getting behind the curve and being forced to react belatedly -- and aggressively. That's a 'crash up, crash down scenario' where yields go up aggressively creating a sudden monetary tightening that ends in the economy stalling and a massive frontrun toward lower yields.

Where we've been since Q1 is in the Goldilocks scenario with yields range bound. Policy is neither too hot nor too cold, giving risk assets room to run. I've been calling this period The Interregnum though, because we're likely in a regime shift but it's not clear how committed the Fed is to that shift of you listen to Roach and Summers.

This is an environment to foster Minskyian stability that breeds instability. But sometime in the Summer to early Fall, the Interregnum will be over. And that's when we should expect volatility to rise. Enjoy the low volatility while you can.

P.S. - Shout out to the excellent John Authers who picked up on that piece I wrote yesterday. You should read his take. Link here.

The Death of the US Treasury Bond Vigilante

Earlier today, Bloomberg reported that the yield on a 10-year US Treasury bond fell below 1.50% for the first time in months. And this happened literally the day before a consumer price inflation number expected to come in at 4.7%. That means the US ten-year yield is deeply negative in real terms. The question is why. And what does this mean for bond investors?

“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But know I would like to come back as the bond market. You can intimidate everyone.”

-James Carville, Advisor to President Clinton, 1993

Oh how times have changed. The bond markets aren't intimidating anyone right now. It's the Fed doing all the intimidation at the moment. Here's why. And forgive me if you've heard this speech before.

The Federal Reserve is the monopoly supplier of reserves. And so, the smart money in markets understands that the Fed, as a monopolist, will always be able to hit its federal funds target. And so, if we think of long-term interest rates as a series of future short-term interest rates smashed together, it becomes clear that long rates are heavily influenced about market expectations for future policy.

So, think of the bond vigilantes less as vigilantes intimidating in the Carville way and more as prognosticators frontrunning future policy decisions. Let's call them Bond Frontrunners.

What the Bond Frontrunners are telling you is this:

  1. The Bond Frontrunners believe the Fed now when the Fed says it will keep rates at zero even though real yields are deeply negative. That doesn't mean they won't change their mind. For now though, they have acquiesced.

  2. Just maybe some frontrunners are starting to actually believe inflation is transitory. We're at the period of maximum uncertainty on the transitory inflation score. So, beliefs on this are completely speculative. Even so, they won't actually matter unless the Fed's reaction function is inflation-dependent.

  3. Bond Frontrunners are starting to think the Fed's reaction-function may not be as inflation-dependent anymore. Unemployment is front and centre. And that's reason to accept lower yields.

  4. Whether inflation is transitory or not is irrelevant. As long as the Fed is the monopoly supplier of reserves, it can suppress yields to its heart's content. And there's nothing we can do about it.

You put all of this together and it speaks to another potential widowmaker trade in the making, where the so-called vigilantes had a go at the Bank of Japan over and over again. And the BoJ beat them back decade after decade even as the government debt to GDP soared well over 200%. This speaks to the monopoly power of the central bank.

I don't think it's any different with the Federal Reserve even if the US has a current account deficit. All it means is that the currency will be the release valve.

So how do we trade this?

  1. Watch the employment and jobless claims prints. That's where Fed policy is geared. That's what moves the needle on rates

  2. Inflation is now in the free pass period. Let's see how the market reacts tomorrow to validate that statement

  3. Bad news on the employment front is good news for risk assets because it keeps the Fed on hold. Really, really good news is bad news, especially for high beta shares that are duration-sensitive due to their DCF.

  4. The pain trade is yields lower i.e. where the short Treasury position isn't. And that also happens to be where convexity forces duration-matching investors to buy, resulting in a potential big move down in yields as shorts cover.

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