“Broke all time Stock Market Record again today”, Donald Trump said, at 17 minutes to midnight on Friday.
“135 times since my 2016 Election Win”, the president added. Then, he shouted “Thank you!” into the Twitter void.
It wasn’t clear who he was thanking, but if he’s got any sense at all, it should be the Fed.
Jerome Powell’s dovish pivot at the beginning of the year (a tacit recognition that the US was on the verge of tightening itself into a slowdown) and the FOMC’s eventual acquiescence to the desirability of insurance cuts (largely due to the realization that Trump was, in fact, fully prepared to chance a head-on collision with China if it meant getting rates lower domestically) completely reversed the dynamics that prevailed in Q4 of 2018.
Then, real yields had risen sharply over the preceding months, a tightening impulse that was exacerbated by Powell’s ill-advised “long way from neutral” comment. Breakevens, meanwhile, plummeted as the growth outlook darkened.
This year, real yields plunged as the Fed pivoted, and although breakevens responded to tariff and growth jitters in predictable fashion both in May and August, they have rebounded over October, November and December.
This goes a long way towards explaining risk asset performance, including and especially the fate of domestic equities. Surging real yields sap demand for risk assets, while negative real yields do the opposite.
Meanwhile, rising breakevens over the course of the last two months have helped re-steepen the curve and are a reflection of the brightening macro outlook.
Whether this is sustainable in 2020 is one of the key questions.
It’s not realistic to expect the macro clouds to lift completely. The “Phase One” deal between the US and China doesn’t even begin to address serious structural concerns. For example, Beijing has doubled industrial subsidies over the past five years, doling out some $22.5 billion last year to Shanghai-and Shenzhen-listed companies. Those subsidies rose again in 2019. That’s just one example of myriad stumbling blocks to a more comprehensive deal between the world’s two largest economies.
Meanwhile, last week served as a reminder that Brexit, while now virtually sure to be delivered, still has the potential to be a painful experience.
And yet, as long as there are no geopolitical earthquakes that again raise the specter of an outright global recession, yields can, at the least, limp higher in recognition that even if things aren’t great, they aren’t horrible either.
Meanwhile, the Fed’s asymmetric reaction function should be a boon. “A stronger-than-expected economy is likely to produce only a modest move up in Fed pricing (as we expect inflation to remain subdued), whereas a big disappointment is likely to lead markets to price additional easing”, Goldman’s rates team reckons. “An on-hold Fed, combined with an improving economic backdrop, should still support breakeven wideners”.
Deutsche Bank – whose Stuart Sparks is palpably concerned about the prospect that a stubbornly strong dollar could lead to imported disinflation, especially in an environment where the US economy continues to outperform while the global outlook remains gloomy despite ostensible progress on trade – admits of some upside risk to their own yield forecasts in line with some of the points made above.
“One salient risk for our US yield forecasts is that a Phase I trade deal with China could allow growth to accelerate more in major trading partners than in the US itself”, Sparks says. “On balance, this growth evolution would favor a weaker dollar, modestly higher breakevens, and a modestly larger term premium”. He adds the following:
Within this framework, a 5% depreciation of the real USD TWI would be consistent with an 8 bp increase in 10y BEI, and given the empirical relationship between 10y BEI and the 5s10s vs. 20% 2s proxy for the term premium, would bias the term premium higher by approximately 6 bp. Clearly US growth outperformance and dollar appreciation would have the opposite effect, putting downward pressure on BEIs and the term premium.
All of this might sound somewhat esoteric, but it’s really not. In fact, there’s a sense in which it’s all that matters headed into the new year.
“Equity investors were… able to embrace a three-sigma shock to yields (to the upside) in September amid good news on activity and trade [which] gave something of a sign that markets might be able to transition away from central bank life support without much angst amid a backdrop of stabilizing economic data”, Bloomberg’s Luke Kawa wrote, in the latest edition of “The Weekly Fix” newsletter (you can sign up for free in the upper-right-hand corner of their FI landing page).
“In fact”, he went on to note, “equities soon needed yields to rise to be able to do the same”.