There’s quite a bit of nuance to the US rates story.
As I’ve attempted (with varying degrees of success) to convey over the last 48 hours, it’s not as simple as saying yields were higher on the first two days of 2022 “because inflation” or “because imminent Fed hikes.” Those interested in the relevant contributing factors are encouraged to peruse Tuesday’s lengthy explainer.
Panning both out and in — that is, out to the 30,000-foot macro level and in to the breakdown of rate rise — there are two things to note. First, the market seems to think the economy can cope with tighter Fed policy. Second, and relatedly, it’s the rise in real yields that’s the story.
The figure on the left (below) shows 30-year reals up more than 30bps since early December, when markets were attempting to digest Omicron (and week-old, leftover turkey).
At the same time, 30-year nominals (on the right, above) are through their 50- and 100-DMAs.
“To this point, the vast majority of the move year-to-date in long-end nominals is from real yields moving higher,” Nomura’s Charlie McElligott said Wednesday, adding that market-based inflation expectations indicators “continue chopping, but remain generally sideways.”
As I suggested earlier this week, that’s important to grasp. If breakevens aren’t crumbling, rising real yields either represent “US growth being repriced somewhat higher, or [the] addition of risk-premia due to potential (negative) implications of Fed policy tightening,” McElligott went on to say.
Of course, higher reals equate to tighter financial conditions, and while tech shares are starting to buckle, the factor and thematic trade (i.e., the under-the-hood “stuff”) suggests markets are relatively confident in the economy’s capacity to live with COVID (providing new strains are less likely to cause severe disease, of course) and stomach Fed hikes.
“Where are we seeing this ‘confidence’ in US economic growth?,” McElligott asked, before answering his own question. It was visible in factor behavior, “which shows a clear bullish tilt to ‘Economically Cyclical / Inflation Sensitives,’ and away from ‘Duration proxies,'” Charlie wrote, noting big “green” moves in a 10-year yield sensitive factor, cyclical value, a crude-sensitive basket and small-caps, among other relevant expressions.
On the other side of this trade is anything and everything duration. Plainly, higher yields have the potential to undercut secular growth shares, which have benefited enormously from a decade of “slow-flation” macro dynamics. But more than that, rising real yields are kryptonite for richly-valued hyper-growth and other manifestations of “froth.”
That’s all a dispersion story, and dispersion (or churn beneath the surface) often gives the appearance of relative calm at the index level. The important point, though, is that there’s a fine line between a market that’s willing to countenance tighter monetary policy on the assumption the economy can “handle it” and a market that eventually expresses its displeasure with too much tightening.
The quintessential example of that balancing act gone wrong is, of course, 2018, when Jerome Powell’s double-barreled tightening eventually engendered a mini-bear market in equities and sent tremors across credit (red dot in the figure below).
Why is this relevant now? Well, because the Fed will likely to start balance sheet runoff later this year, something Nick Timiraos previewed on Tuesday.
“Federal Reserve officials are beginning to map out how and when they could shrink their $8.76 trillion portfolio of Treasury and mortgage securities,” Timiraos wrote. “At their policy meeting last month… officials began discussing what should happen to the bond holdings after [the taper is complete], and some are pushing to start shrinking them sooner and faster than they did after an earlier asset-purchase program.”
So, there’s the December FOMC minutes. You don’t even need to read them now. I’m just kidding. But not really.
Recall that Goldman expects runoff to begin in Q4, after a trio of rate hikes (figure above).
On Wednesday, McElligott conjured the ghost of 2018. “The backtest of Fed policy tightening running simultaneously with balance sheet runoff has not been kind, meaning there’s still absolutely room for this hopeful ‘Pro-Cyclical’ rally to get washed out… at the first sign of a harder economic slowdown, or markets ‘tantrum-ing’ with enhanced volatility.”
He then delivered a helpful reminder: “Rate Vol is almost always at the nexus of cross-asset vol spasms and ‘momentum / carry shocks.'”
