The Only Debate That Matters.

“Nascent”.

It feels as though each time the market conversation turns to bear steepening in the curve and any attendant pro-cyclical rotation in equities, the adjective “nascent” is always present. “Burgeoning” is another word that often shows up in those same conversations.

There’s a reason for that. “Burgeoning” and “nascent” imply that any bear steepener and concurrent shift away from equities expressions tethered to the duration trade in rates, is in its infancy at best, and will likely prove fleeting. The figure is one of the simplest ways to visualize the dynamic over time.

We use “nascent” and “burgeoning” in this discussion because we realize that the chances of a durable selloff at the long-end of the curve and a pivot towards things like cyclicals, small-caps, value and high beta in equities (and therefore away from secular growth and bond proxies) likely won’t pan out.

In colloquial terms, it seems like something always intervenes to short-circuit these nascent regime shifts. For example, late last year, many were convinced that with the “phase one” US-China trade deal in place, and central banks having spent the better part of 2019 pivoting back towards accommodation, the stage was set for a strong rebound in global growth and inflation, and thereby a pro-cyclical rotation within equities accompanied by higher long-end yields. Then along came a geopolitical land mine (the assassination of Qassem Soleimani) and on its heels, “a great and powerful plague” (to quote Donald Trump).

To be sure, a volatile bear steepening episode would likely cause problems if it unfolded too quickly with enough ferocity. So, when we talk about pro-cyclical rotations in equities, and higher long-end yields as indicative of healthier growth and inflation expectations, we’re not talking about an explosive steepening episode that abruptly upsets the entire duration trade applecart to disastrous effect.

Underlying this entire discussion is monetary policy and its interaction with curve dynamics.

Over the years, Deutsche Bank’s Aleksandar Kocic has repeatedly described the difference between the “QE mode” of the curve, and “normal conditions”.

Under normal conditions, shocks arrive at the front end of the curve. That entails bull steepening and bear flattening. A regime shift can be observed at the beginning of the QE era, when suddenly, the typically negative correlation between the short rate and the 2s10s flipped.

(Deutsche Bank)

Implicit in that chart is the notion that post-2008, whatever 2s are doing, 10s are doing, only more of it. Hence bear steepeners and bull flatteners. Prior to 2008, it was the opposite. That is, 2s and 10s tracked each other most of the time, but whatever 10s did, 2s did more of the same, to paraphrase Kocic, from a 2018 note.

He reiterates this in his latest, out Friday.

“Under normal conditions, monetary policy shocks originate at the short end of the curve and, as they propagate towards the back end, their effect gets attenuated”, he writes, adding that the situation “clearly changes radically when the short end stops moving and monetary policy is administered through the back end of the curve”.

That is, when the short-end is pinned (at zero), and monetary policy begins to work through QE, “the market metabolizes policy shocks through long rates and the curve responds by bear steepening or bull flattening”, he notes.

The full note builds on that to flesh out the rationale for a trade that will be inaccessible to most readers, but this ties in to the more general discussion mentioned here at the outset. Kocic writes the following in a characteristically brilliant passage elaborating on the QE mode of the curve:

On a purely conceptual level from the perspective of any term structure framework, the QE mode of functioning is unnatural: Yields are compounded short rate, which in turn follows a diffusion process. Thus, having shocks arrive from the back end — and then bootstrapping their propagation through the curve — confuses cause and effect, and can only be reconciled by the idea of administered markets.

“Administered markets” is a concept discussed in these pages at length lately in light of unprecedented accommodation from central banks in the wake of the COVID crisis.

Currently, there’s a somewhat vociferous debate around whether (and to what extent) massive issuance tied to virus relief efforts and any assumed success policymakers have in engineering an economic rebound, together set the stage for higher long-end yields, bear steepening and a pro-cyclical rotation in equities. Talk of burden-sharing in Europe (i.e., the Franco-German proposal for a jointly-guaranteed €500 billion recovery fund) and accelerated reopening plans in the US, potentially argue the point, as does the rapid recovery in oil prices.

The other side of the debate says that with central banks set to absorb most (or all) of the supply associated with virus relief/stimulus, and the acute demand shock set to inflict lasting, structural damage on developed economies, long-end yields are unlikely to rise and economic activity will likely remain subdued for the foreseeable future as a “V-shaped” recovery proves elusive. The latest edition of BofA’s Global Fund Manager survey suggests little faith the “V-Shaped” bounce.

“2020, so far, has been a departure from any market/Fed/vol logic — an exogenous shock causing a social crisis with economic consequences and what might be, in the best case, a transient shock to the markets”, Kocic wrote Friday, before noting that “with the all-in Fed, we are back to the extreme QE dynamics with the only uncertainties persisting at the long end of the curve”.

Later in the note, in the course of discussing different trade expressions in the rates space, Kocic says “the 30Y sector still remains a wild card in the context of interplay between fiscal and monetary legs of stimulus and the open-endedness of the crisis”.

While he’s referencing the specifics around a trade, that short quotable strikes at the heart of the debate. There’s quite a bit of ambiguity right now about how the combination of extreme monetary and fiscal stimulus will ultimately pan out and manifest in rates, given the wholly indeterminate nature of crisis. We are currently experiencing what might as well be overt deficit financing by central banks – monetary policy enabling fiscal policy to a such a degree that even the layperson has begun to grasp the link between central bank bond-buying, massive government bond issuance, and all the “free money” (if you will) being handed out to households and businesses.

If the crisis proves to be short-lived and any structural damage from the lockdowns turns out to be manageable, it’s possible that the policy mix will look over-stimulative in hindsight, and that it will be too late to keep the market from pricing that in. I discussed that possibility in “Here’s A Thought: What If (Almost) Everybody Is Wrong?”

For the Fed, the idea is to strike a balance. Kocic described that balance back in February, when the crisis was just starting to unfold. To wit (more here):

In its original form, the essence of (domestic) QE is to create a demand shock. By compressing the term premium of nominal curve real rate is pushed lower and, as the front end is anchored at zero, the response of the long end becomes a referendum on the success of monetary policy. In that environment, there is only one trade: Everything is correlated with breakevens. If demand shock is effective, breakevens widen and push real rates further down, which becomes reinforcing as low real rates stimulate more consumption and, in principle, raise price level. This is articulated as bear steepening of the curve and is synonymous with the risk-on trade. Conversely, failure to reflate the economy makes the Fed action futile with compression of breakevens pushing real rates higher and inhibiting consumption. This is the risk-off mode with bull flattening of the curve.

Suffice to say many believe the latter outcome is more likely than the former given the sheer scope of the demand shock to the economy. A complicating factor for the Fed is the dollar which, you should note, is still sitting about where it was at the end of February, even as it’s come down from levels seen in March. Recall this passage from the same February note by Kocic:

What could happen if the Fed cuts rates in order to weaken the USD? A (temporarily) weaker dollar would imply a stronger EUR (or CNH), which would undermine the effects of foreign QE. As a consequence, the market would likely price in more severe (or extended) QE abroad, which would further compress their yields and create another demand for US assets and USD and, thus, offset the effects of the Fed action – we would be where we started. This would force another round of rate cuts in the US with repeated response abroad causing further rate cuts until US rates catch up with their counterparts abroad. This is the troubling destination that poses the most severe long-term risk. If we reach the point of zero rates without being able to inspire growth (and some inflation along the way) either abroad or in the US, we would find ourselves in the disinflationary world with low growth and no policy tools to combat it.

Fast forward nearly four months from when those words were written and the Fed is at zero, the dollar is stubbornly resilient even in the face of bets for negative rates stateside, and the prospects for a pickup in growth and inflation are obviously bleak – at least in the near-term.

Making matters worse, a rise in US-China tensions and the possible derailment of the trade deal could serve to bolster the dollar further, no matter how accommodative the Fed comes across. That could further undermine the Fed’s quest to bring inflation up to target.

This goes a ways towards explaining why Kocic’s colleague Stuart Sparks has argued that the Fed will need to buy enough bonds to engineer the equivalent of a –1% policy rate, assuming Powell and co. continue to insist that cutting rates below zero isn’t something they’re likely to consider.

“The Fed has clearly communicated its view that additional stimulus in the near term is best provided by balance sheet growth rather than cutting rates below zero”, Sparks wrote earlier this month. “That degree of balance sheet growth creates a substantial supply/demand imbalance, even given elevated Treasury supply”, he went on to say. “These conditions are bullish for bonds and bearish for the term premium”.

And that brings us right back to the bull flattening impulse and the difficulty inherent in what it is the Fed is trying to accomplish. They need to enable deficit spending with trillions in debt monetization, which, if it all works as planned, will overwhelm the negative demand shock caused by the virus, thereby pushing up on breakevens and down on real rates, while averting a situation where a newly-“woke” public suddenly becomes aware of the explosive nature of the policy mix, leading to an undesirably large surge in inflation expectations, amplified by successful reopenings and the absence of an aggressive second virus wave.

All of the above describes the contours of the only debate that really matters right now for markets. In just a few words, it’s a question of getting it just right when it comes to relief/stimulus, while understanding that the variable (the trajectory of COVID-19) which will determine whether the amount of fiscal and monetary accommodation delivered is too little, too much or just enough, is beyond our ability to predict.

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