The Most Vexing Quandary Of Them All

The September jobs report won’t be the only thing worth watching for market participants in what promises to be an eventful week.

On the economic front, consumer confidence, ISM manufacturing, personal spending, and, of course, jobless claims, are also deck. In addition, traders will hear from a bevy of Fed speakers, including Williams, Bowman, and Kashkari.

Given the busy docket, it’s unlikely that any single data point will move the needle or otherwise shift the macro narrative, especially given i) virus “noise”, and ii) the market’s penchant for “waiting on payrolls” during NFP week. It’s also month-end, which could make separating signal from noise even more difficult.

In his week ahead rates preview, BMO’s Ian Lyngen laments that the evolution of the fundamentals doesn’t matter as much as it once did. “If there’s been one consistency throughout the last six months, it has been an abandonment of a reliance on what one might have previously assumed would drive market pricing and valuations”, he remarks.

The ambiguity lies in the overlapping nature of the crises. The pandemic laid bare the myriad inequities of American society, which in turn added another dimension to the equal rights protests. At the same time, the election result will either reinforce those endemic inequities, or usher in a policy shift aimed at ameliorating them.

“Spending would likely rise by at least as much as tax revenue, even beyond the short-term stimulus package”, Goldman says, of a possible Democratic sweep. “Neither political party is particularly focused on budget deficits at the moment, so unlike some prior tax increases that aimed primarily to lower the deficit, we would expect that any tax increase would go to fund new spending programs, particularly those that are seen as more permanent in nature, like health subsidies and other social benefits”.

While the implications for rates over the longer-run are clouded by the likelihood that even under unified Democratic government, aversion to “sticker shock” and long-held deficit dogma will mean no “New Deal 2.0” materializes, in the near-term, a “blue wave” would likely result in a back-up for long-end yields.

The push-pull between these forces (on one side, the virtual impossibility of convincing establishment politicians from either party to cease and desist from trafficking in myths about what deficits actually are in the interest of bringing about transformational change in the US economy, and, on the other side, the presumed tradable selloff in rates that would accompany a shift away from Trump’s supply-side gimmickry in favor of demand-side stimulus) will define the rates trade for years to come.

“The 2021 outlook for US rates will soon become topical and given what we’ve heard from the Fed recently, it’s a foregone conclusion that ZIRP is here for an extended residency”, BMO’s Lyngen went on to say Friday, noting that the bank’s base case for the next 24 months is that Treasurys will remain in a 75-100bps range from 10-years out the curve.

“This speaks to the very real potential for a selloff that brings 10-year yields to 1.0% in the event November brings swift political clarity and the way is cleared to price in greater economic optimism for the coming quarters”, he said, elaborating, before noting that “it also implies any meaningful back-up in rates will be short-lived and provide a buying opportunity for those eager to add duration exposure at ‘cheaper’ levels”.

You probably noticed the reference to “swift political clarity” above.

In the event there is no such clarity, one assumes a bid for the long-end would materialize as markets flip the switch to risk-off amid unprecedented domestic turmoil and likely social unrest.

However, this time could be different when it comes to the market’s almost unshakable faith in US Treasurys as a safe haven.

One of the great ironies of periods during which America’s creditworthiness is called into question is that the very instruments which are purportedly in doubt (i.e., US Treasurys) end up bid. But there really is no precedent for a situation that finds the market confronting a literal shift in America’s form of governance (i.e., from democracy to soft-authoritarianism).

That would present market participants with the most vexing quandary of them all: Does it make sense to seek shelter in the world’s safe haven asset par excellence in a scenario where that asset will henceforth represent an obligation of an authoritarian government?

Note that this isn’t really a hypothetical anymore. We’ve seen multiple previews of it over the past three years. The Trump administration’s Iran sanctions really just amount to the weaponization of the USD. The same is true for some lawmakers’ “genius” suggestion that the US should work out a scheme that would allow the Treasury to somehow selectively default on a portion of what US politicians mistakenly refer to as “debt owed to China”. (I say “mistakenly” because US Treasurys are not IOUs to specific countries, they are interest-bearing dollars that circulate as highly liquid securities, and can therefore be sold at any time to someone else).

With the first presidential debate set for Tuesday, I think it’s critical that market participants (and, really, everyone) understands that what once seemed like science fiction is now on the radar, if only as a tail risk.

“It’s become fairly consensus at this stage that most possible election outcomes will be contested — to one degree or another”, BMO said, in the same note cited above, adding that it’s hard to know how much of that is priced in considering 10-year yields sit at just 65bp and stocks have, in fact, sold off recently. Lyngen and his colleagues Jon Hill and Ben Jeffrey write that they’re in the same boat with “most others” — namely, compelled to “assign a very low probability to a ‘non-peaceful’ transition of power… in the event Biden wins the White House”.

Here’s the thing, though. The tail risk for markets (and especially the UST market) isn’t really a “non-peaceful transition of power”. Rather, it’s a “non-peaceful, non-transition of power”.

And, again, this is no longer science fiction. It’s possible. Is it likely? No. But it’s possible nevertheless.