A Rather Strange Place

Another week went by and the title and subtitle atop my simple, daily chart of 10-year US yields still says the same thing.

There’s a “calm despite the storm” as 10s “remain rangebound amid a tenuous macro standoff.”

After shooting up near 1.80% during Q1’s mini-tantrum, yields have settled into a sideways drift (figure below). “Momentum’s urgency has waned,” BMO’s US rates team said, adding that “a sideways shuffle would feature the local yield high at 1.704% for support, with the true bearish litmus test 1.774% that we anticipate will be unbroken until at least Labor Day,” they added, in a Friday note.

But this “sideways shuffle” is set against pervasive macro uncertainty exemplified by the hottest inflation data many younger market participants have ever seen and an unmooring of near-term inflation expectations among consumers.

On Friday, for example, core PCE printed the highest since 1992 and the final read on University of Michigan sentiment was accompanied by color documenting unprecedented spontaneous mentions of higher prices.

A simplistic take might be that everyone is in “wait and see” mode. Is the inflation spike “transitory” or isn’t it?

But that’s a bit unsatisfying considering the ostensibly “frightening” nature of visuals like the second figure (above) and the shrill character of the “overheat” warnings emanating from the likes of Larry Summers, who Bloomberg paid to reiterate familiar talking points on Friday.

For his part, Deutsche Bank’s Alan Ruskin says “US nominal back-end yields near current levels are particularly attractive for foreign buyers when short-end hedging costs are so low.” In other words, long-end Treasury yields are effectively capped by super-low yields in most liquid, safe-haven alternatives.

Ruskin elaborated. If, in fact, nominals in the US are limited in their capacity to rise despite higher inflation expectations, “the identity relationship implies that real yields have nowhere to go and will remain at unusually low levels relative to real growth expectations,” he said.

For Ruskin, this hints at “a unified macro theory,” that helps explain various market dynamics including “bond yields struggling to break higher, despite extraordinary bearish inflation news,” deeply depressed reals (which are now totally disconnected from the US growth outlook), a dollar that struggles to rise (Ruskin noted net portfolio inflows are mostly hedged) and, of course, resilient equities “even in the face of higher inflation expectations, because nominal yields are restrained, and real yields are so low.”

There are, of course, caveats. Ruskin conceded that “one months worth of evidence that foreign flows into US Treasurys are strong” probably isn’t sufficient, and many market participants “are skeptical that large foreign bond inflows continued in April and May.”

Beyond that, though, the crucial question going forward is what becomes of the Fed bid, which Ruskin noted is “absorbing on average 40% of new issuance in recent quarters.”

The risk-friendly backdrop facilitated by “a well-behaved US bond market, with capped nominal yields, inflated price expectations [and] very soft real rates is likely to be increasingly challenged in the second half of the year,” Ruskin said.

Obviously, monetary policy has been exceptionally accommodative for the duration of the pandemic, but some central banks have taken the first tentative steps down the road to normalization, with more likely to follow (the figure, below, shows Deutsche Bank’s expectations).

“The shift in policy emphasis, at first in balance sheets, should become more self-evident into H2,” Ruskin remarked, on the way to suggesting that the key consideration will be whether the COVID downturn is viewed as a cathartic release of “past excesses” from which a new cycle was born, or “simply… a brief collapse in GDP that is about to be quickly retraced,” in which case one might argue we’re actually in the latter stages of “the old mature cycle.”

The idea that the pandemic collapse was just a deep pothole we ran over, rather than a cliff we drove off, is becoming more popular.

Between projections (from at least a few banks) that trend growth will actually end up higher than it would have been had the pandemic never happened, and the ever longer list of data and indices that now exceed pre-pandemic levels (e.g., retail sales in the US, various equity market benchmarks, etc.), the post-pandemic environment is shaping up to be a rather strange, bifurcated place.

Ours is a reality defined by a stark juxtaposition between i) the “better than ever” dynamic evident in some areas and ii) utter devastation, including the massive loss of life and complete destruction of livelihoods, in others.