‘We Disagree With Every Element Of This Narrative’: Why One Bank Doubts A Consensus Bond Trade

Lost in the fog of “whale tales” and superseded in the news cycle by the Nasdaq’s brush with a technical correction, was an aggressive selloff at the long-end of the curve Friday.

10-year yields rose 9bps and 30-year yields 12 on the heels of an August jobs report that, at least on the surface, met expectations.

Prior to Friday, the story of the week in rates was the unwind of the bear steepening impulse from Jerome Powell’s unveiling of average inflation targeting. That unwind was itself partially unwound to close the week, as the 5s30s steepened more than 5bps.

In addition to the jobs data, the market appeared to be doing some prep work (if you will) for next week’s supply deluge, which includes 10- and 30-year reopenings as well as the expected seasonal tsunami of investment grade issuance.

That overhang likely short-circuited the flight-to-safety bid which may have otherwise shown up Friday amid a second day of losses for stocks, which fell hard over the US morning before paring the worst of the slump.

Note that September’s IG slate comes on the heels of a record-shattering year for high-grade supply, as blue-chip US borrowers took advantage of the favorable conditions created by the Fed’s inaugural foray into corporate credit. August ended up seeing nearly $140 billion in new sales, well more than dealers expected. September should be good for another $140 (give or take).

This is part and parcel of why some expect this month to be challenging for bond bulls, and possibly for equities, which may or may not be prepared to digest a selloff in rates.

We’re now squarely back in “QE mode” when it comes to the curve. Shocks arrive at the back-end, leaving fiscal policy/coupon supply and asset purchases/QE to shape outcomes.

“The reality of the moment is that for wider curves — think 2s10s or 5s30s —steepening or flattening is entirely a function of duration’s performance”, BMO’s Ian Lyngen, Jon Hill, and Ben Jeffery said Friday.

When it comes to the steepener, Deutsche Bank’s Stuart Sparks has been skeptical for quite some time, and he remains so despite the Fed’s unveil of average inflation targeting.

“The bearish steepening narrative ran something like the following: seasonal bull flattening — which is early this year! – provides an entrance point for steepening for which the catalysts are structural increases in Treasury supply and the Fed’s shift to soft average inflation targeting”, he wrote Thursday, recapping, in his latest note, before emphatically reiterating that “we disagree with every element of this argument”.

He goes on to say that while it was reasonable to expect a concession to get built into the record refunding, that should be “transitory, rather than the beginning of structural steepening”. You’re reminded that August saw the biggest steepening in the 5s30s in years, on the heels of the largest flattening since 2017 in July.

So, why should any steepening impulse be “transitory” given the supply backdrop?

Well, for Sparks, the answer is a combination of Jerome Powell outrunning (if you will) Steve Mnuchin and Ricardian equivalence blunting the impact of stimulus, leading to increased private sector savings.

“At the current pace of purchases and at our forecasts for Treasury supply, QE demand for the year will outstrip net coupon supply by around $465 billion”, Sparks says, adding that,

This demand is coupled with a remarkable increase in private savings due both to the Ricardian equivalent response to public sector borrowing and increased precautionary savings due to the COVID shock. During the April-July period, personal savings was $1.45 trillion, up 271% from the same period last year.

But what about average inflation targeting? Doesn’t the Fed’s explicit pledge to countenance overshoots to make up for past shortfalls presage a steeper curve, especially when taken in conjunction with massive Treasury issuance?

In a word, “no”. In several words (from Sparks):

The Fed/inflation catalyst, in our view, is toothless as well. “Tolerating” higher inflation presupposes the ability to produce higher inflation. With the stalemate in Congressional negotiations over Phase 4 fiscal stimulus, hopes for a material and persistent boost to activity and inflation likely hang precariously on a one-party government, again suggesting that additional monetary stimulus is needed as insurance, if not as the only source of additional stimulus.

From there, the argument falls neatly into place. In order for the Fed’s commitment to stoking inflation to be credible, they’ll need to ease further (i.e., they’ll have to actually do something, not merely talk). Having explicitly ruled out negative rates, and having shelved yield-curve control (at least for now), the only other options are more asset purchases and an increase in WAM.

Sparks calls both of those “highly likely — something like 80-85%”. “We continue to see increases in the dollar duration drain via QE as a necessary component of policy next steps, even if not sufficient”, he goes on to say, summarizing. (In remarks earlier this week, Lael Brainard seemed to confirm this, by the way.)

With all of that in mind, and with August having produced the opposite of the traditional seasonal bull flattening, Sparks’s view is that “the seasonal reversal typically observed during the autumn will also fail to materialize on a persistent basis”.

One thing’s for sure: a disorderly bear steepener is (or at least should be) a total non-starter in the Eccles building, for a variety of obvious reasons.

So, while there are myriad purportedly “common sense” arguments for a steeper curve, they may all fail in the face of a determined buyer armed with a printing press, especially given that other options (e.g., negative rates and YCC) for enhancing the credibility of the new policy framework have been taken off the table.