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:
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.
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.
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.
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?
Watch the employment and jobless claims prints. That's where Fed policy is geared. That's what moves the needle on rates
Inflation is now in the free pass period. Let's see how the market reacts tomorrow to validate that statement
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.
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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I would tend to agree with this thesis, most of the time. However, just because CPI inflation isn't yet permanently out of hand (it's certainly out of control on a transitory basis, but when taking account of quirks due to the pandemic, such as used car prices, and issues with new cars due to chips, it's not as bad as it seems), it's not clear just how much above the 2% target it will end up once we let employment run up, while global demand pushes on materials prices and commodities. But even if we assume the eventual running rate is around 2.5-3.0%, well above target, we have seen before where the Fed ignores this as well, long enough for other situations/shocks to crash the party.
The problem this time around, more than ever, is that low rates (especially when combined with massive fiscal stimulus) have teed up epic asset price inflation. Eventually the third leg of the stool is going to reassert, and even if UE isnt below 4% and inflation is comfortably below 3%, they aren't going to be able to ignore this much longer in the name of reining in risks to financial market stability. The longer this bubble inflates, the worse the damage when it goes down. (See 2001) Macroprudential controls via regulation, etc, arent going to rein in the mortgage industry. Just talking with people around the country, the bubble behaviors are back in force - maybe not lending to dead people or dogs, but appraisals being adjusted after the deal to hit targets...that isn't going to end well. And the COViD demand has run its course, as will the reluctance to list properties due to COVID, or waiting for still more home price inflation. First sign of a slowdown, a flood of properties is going to hit the market. And they havent even figured out how to end forebearance!
I just dont see how we keep asset prices at these levels; equity valuations are way too dependent on their own valuations propping demand across the economy (which provide money for home downpayments, which in turn provide money for homeowner spending), and low rates. Actual underlying demand is much weaker than before the pandemic once you remove the transitory fiscal expenditures. And it looks like Congress is fully dysfunctional again, so there isn't going to be an infrastructure or any other spending to keep that game going. And once equities unravel a bit, especially if caused by any less accomodative Fed policy, housing will unravel next, then confidence, etc, then the Fed will be in its box, grabbing its hammer (low rates) and looking at everything that appears to be a nail.
I dont know how we get out of this boom and bust cycle, especially now that Manchin and Sinema are going to tank the Democratic agenda, and we will get two years of nothing before going back to Republican control.
So, as for the widowmaker, yeah, that is a boom bust too, but at a very low level of rates, with people getting constantly caught on the wrong side of things. For now, they will see a brief slump in rates, but if it turns out the Fed has guessed wrong on actual sustained inflation, or even more out of control asset prices, and has to change its tune, bond prices crater. But they can only crater so long before they take down the leverage based growth system. Then back down bond prices go. This is the path to negative rates in the next cycle.