Well, you can expect the week ahead to be dominated by relentless hand-wringing over bonds and the extent to which Friday’s 3M-10Y inversion presages famine, pestilence and, naturally, locust plagues.
To be clear, Friday’s action doesn’t bode particularly well, but it was a bit of a “perfect storm”, so to speak, and by definition, “perfect storm” scenarios are anomalous.
JGB yields had to play catch up (or, actually, “catch down” is better) to the dovish Fed after a holiday and the Japan CPI miss threw gas on the fire. Then came the grievous German manufacturing data and it didn’t help that France’s composite PMI sank back into contraction territory. Ultimately, the die was cast by the time the US session got going.
The data from overseas underscored growth concerns and, more importantly, appeared to lend credence to the idea that the Fed’s dovish surprise on Wednesday might have been predicated on the FOMC “knowing something” everyone else doesn’t know.
As BofAML’s Hans Mikkelsen reminded folks on Wednesday, “communicating dovishness is always tricky as there is a delicate balance between the benefit of stimulus and the underlying driver, which is economic weakness”.
Even the best communicators can get tripped up trying to toe that line, with Draghi’s March presser being a rather poignant example (the depth of the cut to the euro-area growth forecast more than offset any risk-on vibes from the announcement of a new TLTRO).
Powell appeared to have succeeded in leaning dovish without “validating” the market’s worst growth fears (the SEP downgrades weren’t dramatic and he struck an upbeat tone in the presser) but ironically, the juxtaposition between his generally optimistic take on the US economy and the clear inclination to underscore a dovish stance was so stark that it raised questions.
Friday’s data from overseas was seen as “answering” some of those questions. And so, cue more demand for bonds and the inversion.
And bring on the equity “freakout.”
That’s the setup for a week that will see the market absorb some $131 billion in supply, and all as everyone tries to sort out the implications of the balance sheet plan as delivered last Wednesday.
For what it’s worth, Goldman is out with some commentary on all of this and you won’t be surprised to learn that they now see downside risks to their 2019 yield forecasts.
“Yields [are] likely to peak later in the cycle than we are currently projecting”, the bank wrote Friday, citing “a more decisive no-hike consensus for 2019 than had been expected” in the dot plot. The bank also notes that “external weakness and spillovers from other rates markets are a further source of downside risk to our US yield call.”
That “external weakness” and those “spillovers from other rates markets” are precisely what we got on Friday as described above.
The other critical dynamic here is the outperformance of reals amid the Fed pivot and ongoing global capitulation from central banks. “Real yields are typically directional with nominals, with a 0.65-0.7 long-run beta of monthly changes in real yields on nominals [but] year-to-date 5y and 10y TIPS yields have rallied 55 and 48bp respectively relative to nominal rallies of 16 and 17bp — reflecting 44 and 38bp of outperformance versus what the beta would imply”, Goldman goes on to marvel. That, in turn, as put some wind in the sails of risk assets which then bolsters the reflation narrative and breakevens.
Finally, if you’re wondering what the actual impact is from the Fed’s post-September plan for the balance sheet in terms of restoring the “flow” effect, Goldman has a back-of-the-envelope calculation on that.
Recall that from October, principal repayments from agency and MBS securities will be reinvested in Treasurys “subject to a maximum of $20 billion a month.” Here’s Goldman to explain what that means:
With an estimated $17bn a month in MBS runoff and the average duration of USTs outstanding at ~54 months (approximately that of a 5y note), this roughly equates to the Fed taking ~8-10bn in 10y equivalents out of the market; that’s compared to $30, 60, and 40bn 10s of monthly purchases under QE1, QE2 and QE3 respectively.
In short, the flow impact should be “modest”, Goldman writes. At some point, the Fed will probably attempt to shorten WAM in order to free up room for another Operation Twist later on down the road – that, you’re reminded, would increase the potency of an assumed easing push during the next downturn. Conversations about the future composition of the balance have presumably already commenced, although Powell was keen to suggest last week that the committee isn’t anywhere close to making a decision on that.
All in all, the bottom line is captured in the title of Goldman’s note: “Dovish Fed, weak data – a bond’s best friend.”
The problem, as we saw on Friday, is that the “weak data” part of that equation has the potential to undercut risk sentiment materially as it casts doubt on the notion that central banks will be successful in engineering reflation.