The market reaction to a blue sweep in Georgia was about like one would expect.
Raphael Warnock defeated Kelly Loeffler, becoming the state’s first African American senator, and Jon Ossoff eventually prevailed over David Perdue to become the youngest senator elected in four decades.
In response, 10-year yields jumped ~7bps, pushing beyond 1% which had served as a “ceiling” of sorts. At the least, the breach has symbolic meaning. Some suggest it could set in motion “a domino effect across asset classes,” as Bloomberg put it, dramatizing the situation in a Wednesday piece.
10-year breakevens crossed 200bps earlier this week, and 10-year real yields tumbled to record lows. The results in Georgia should serve to entrench this conjuncture, at least in the near term. In the lead-up to the vote, the 5s30s steepened to fresh four-year wides.
With Warnock and Ossoff in, expectations for stimulus payments to be upped from $600 to $2,000 will build, and while a razor-thin majority would make it difficult for Joe Biden to push through anything too ambitious, the market will start to price in more Treasury supply, and “worse” deficit outcomes. Chuck Schumer suggested Wednesday that the $2,000 checks will be one of the first orders of business.
“The more left-leaning Democratic plans are likely to meet with resistance from centrist Democratic senators,” Rabobank’s Philip Marey said. “In a 50-50 Senate, one dissident Democrat can block his/her own party [so] we should not expect the whole Democratic agenda to become reality,” he added.
“Even though the Fed remains committed to QE until the economy improves, it didn’t extend the WAM of QE purchases at the December meeting,” TD remarked this week. “The market may be concerned that the Fed backstop may not be sufficient to keep rates unchanged in the face of significantly more supply, though we expect buyers of duration to emerge once 10s move above 1% since COVID cases continue to increase and we expect weak economic data in the near-term,” the bank’s Jim O’Sullivan went on to say.
That underscores a key point: The Fed likely won’t allow long-end US yields to spiral higher in disorderly fashion. Any kind of vengeful (if you will) bear steepener would be snuffed out by, at the least, explicit allusions to possibly imminent WAM extension. After all, the FOMC will want to foster loose financial conditions for the foreseeable future.
“The extent to which the Fed will be comfortable with higher Treasury yields will also become essential very quickly,” BMO’s Ian Lyngen and Ben Jeffery wrote Wednesday. “The Committee is surely encouraged to see inflation expectations rebounding and will concede a steeper curve must follow – but only to an extent,” they added, before noting that the prospect of WAM extension “will remain a binding constraint for any more aggressive bear steepening in the near-term.”
Between that, and the paltry yield on offer in other developed sovereigns, dip-buying in USTs is probably inevitable at some point.
The easy (one might even call it “lazy”) read-through for the dollar is negative. “Given our expectations that the Fed will remain highly accommodative — even if transitory inflation appears in the coming months — inflation expectations are likely to outpace nominal yields, pushing down real yields and weighing on the USD,” Citi said. Others echoed that assessment.
Of course, it’s also possible that bigger spending and demand-side stimulus lead to more robust economic outcomes that ultimately bring forward Fed normalization. Economic outperformance (versus baselines and versus, for example, Europe) and the prospect that the Fed may be able to start dialing back extreme accommodation sooner, could be dollar positive.
For now, though, one should probably expect knee-jerk bear steepening, higher breakevens, even lower reals, and dollar weakness.
“The outlook for the dollar is less clear-cut than stocks and rates in my view,” AxiCorp’s Stephen Innes said Wednesday. “The risk-on sentiment is dollar-negative as capital gets allocated elsewhere [but] the US economy will recover quicker than Europe, particularly as Biden aggressively pushes vaccination efforts.”
For equities, it will be all about dispersion again, as big tech and secular growth favorites will probably come under pressure, while small-caps and value will be favored on the assumption that this time, the pro-cyclical rotation can prove some semblance of sustainable.
Worries about the effect of rising yields on equities sporting lofty valuations will proliferate assuming the backup at the long-end proves durable. Remember, it’s the rapidity that matters more so than the absolute level — at least to a point.
A two-standard deviation move to the upside in 10s could be destabilizing. But we’re a long way from that (10s would have to make it all the way to ~1.30% by the end of the month, a tall order).
As far as the prospects for tax hikes, it’s probably too early to fret about that. Let’s clean up Capitol Hill from the riots and make sure the government is still intact before we go worrying about our accountants.