Heisenberg Report

Look Out: Market Reaction To Spending Deal, 10Y Auction Proves We’re Not Out Of The Woods

Ok, dammit. How many times have we said over the past 18 hours that it was just a matter of time before everyone gets over their fascination with the spectacle of the short vol. crowd bleeding to death in the streets on the way to stepping over the bodies and getting back to focusing on what caused things to go wrong in the first place, rapidly rising yields?

I don’t how many times we’ve said that since yesterday afternoon, but we’ve said it a lot. For instance, here’s an excerpt from a post we ran Tuesday night:

But it’s entirely possible that once the shock wears off, we’ll be right back to focusing on the potential for upside surprises on the inflation front to force central banks to withdraw transparency by effectively cutting the cord with markets and leaning aggressively hawkish in order to avoid falling behind the curve. If, on the other hand, the Fed (for instance) were to stick with a gradualistic approach to hiking in the interest of not risking a policy mistake (like say bear flattening us into a fucking recession), they risk seeing the curve aggressively bear steepen on them as the market prices in not only rising inflation pressures but also expansionary fiscal policy and the prospect of more supply from Treasury at time of waning foreign demand and Fed balance sheet rundown. In other words, we may be out of the woods on the technical risk associated with the VIX ETP rebalance by virtue of the deck being cleared, but what happens when everyone remembers why we were worried in the first place?

And then there was this on Wednesday morning:

The issue – as we’ve been over countless times – is the rapidity of the rate rise. There is a limit to the equity market’s patience when it comes to higher bond yields (and higher breakevens). Previously, the bond market adjustment was viewed as a good thing to the extent it signaled something about the relative robustness of the economic recovery. But the rapidity of the rise in yields matters. Too far, too fast is not good and past a certain point, equities’ interpretation of that yield rise will change.

So, now that the logjam on the highway is starting clear as people stop slowing down to rubberneck it while driving by the smoldering wreckage of the Target manager-turned vol. seller debacle, the focus is indeed back on the bond selloff and on Wednesday afternoon, we got two potential catalysts for another move higher in yields. One was a weak 10Y auction and the other was the budget deal which includes higher spending and a suspension of the debt limit. The result:

So there’s that, and here’s ES:

There’s still a lot of headline hockey going on around the debt limit and the spending deal, but the point here is that the dynamics that drove last week’s selloff are still in play.

The notion that expansionary fiscal policy and the ballooning deficit are set to weigh on the Treasury market a time when foreign demand is in question and the Fed is running down the balance sheet has the potential to conspire with the headline risk surrounding the internals on auctions to reignite the bond selloff and thereby pull the rug out from equities that are trying desperately to rebound after the vol. shock.

For whatever it’s worth. Which won’t be much I’m sure, until something else bad happens and everyone is back talking about yields again.