It’s a good thing the yield curve doesn’t matter. If it did, we’d be in trouble.
On Friday, another solid US jobs report accompanied by a rock-bottom unemployment rate and an uptick in participation appeared to cement a 50bps Fed hike at next month’s policy meeting. That, in turn, manifested in yet another selloff in Treasurys out to the 10-year sector.
Outsized front-end losses unleashed a dramatic bear flattener that inverted the 2s30s and drove the 5s30s deeper into inversion (figure below). A 50bps move from the Fed in May was ~80% priced as of Friday afternoon.
“In the aftermath of the jobs report, large block sales in September 2022 eurodollar futures added to bear flattening momentum as the eurodollar strip aggressively sold off out to red-pack futures,” Bloomberg’s Edward Bolingbroke noted. A large block sale in five-year futures added still more pressure later in the session.
Note that next week’s data docket is very light stateside, which means the March Fed minutes have the potential to dictate price action in the void. “It’s one of the most tradable Minutes releases in recent memory and, if anything, we expect that it will serve to reinforce the ongoing flattening bias,” BMO’s Ian Lyngen and Ben Jeffery wrote Friday.
Bonds are coming off their worst quarter ever, which may argue for a bounce (i.e., a rally at the long-end) especially in the event geopolitical developments deteriorate and the growth outlook darkens. That might sound counterintuitive given inflation realities, rate hikes and QT, but remember: Stimulus is supposed to be inflationary. Removing it and engineering tighter financial conditions is designed to cool things down. If corporate profits start to crack and growth momentum wanes, it wouldn’t be surprising (at all) to see long-end yields retrace lower.
“The bias in Q2 is toward higher yields as the market digests the schedule of SOMA portfolio runoff and the rate hike path, but with such a dramatic move in yields, we could see a repeat of last year, with yields mostly sideways after the Q1 selloff as the market is priced to perfection for rate hikes in the upcoming years and with risks skewed to the downside,” SocGen’s Subadra Rajappa said.
Certainly, recent events rhyme with Q1 2021, but there are obviously big differences. Most obviously, the developed world is experiencing price pressures the likes of which many market participants haven’t lived long enough to remember, and central banks are in the process of responding accordingly.
The irony is that the inflation shock and accompanying monetary policy response may be what kills the burgeoning bond bear. “The Q2 contrarian ‘pain trade’ is long bonds, short commodities as investors discount a ‘growth shock’ from the ‘rates shock,'” BofA’s Michael Hartnett said. That’s not his base case, but it underscores the point: The curve is ostensibly telegraphing a policy-induced slowdown which, if it comes sooner rather than later, could cap long-end yields. Unless, of course, efforts to avert excessive consumer pain and ameliorate the political ramifications of expensive gas and food end up forestalling demand destruction, thereby supporting prices in true “irony of ironies” fashion.
Coming back to curve, expect to hear plenty of “false positive” banter. “The 3m10s curve gave a false signal during the 14 months leading up to the 1990 recession [and] it is also worth noting that the 5s30s curve entered the hiking cycle much flatter than it was in the past and inverted in record time after the first hike,” TD’s Priya Misra and Gennadiy Goldberg remarked, adding that it’s “therefore not straightforward to conclude that an inversion is an ominous harbinger of recession.”
For his part, Rabobank’s Philip Marey wrote that at least for the 2s10s, it’s more useful to think about inversions and recessions in terms of thresholds other than zero. That is: How deep does the inversion have to be to raise the odds of a downturn? “The threshold for 3m10y is not statistically different from zero [but] the threshold for the 2s10s is -16bps,” he wrote, in a Friday note. “This means that an inversion of the 2s10s forecasts a recession only if the spread is below -16bps.”
In short: Who knows. About all we can say is that if we’re “a long way from neutral” (to employ Jerome Powell’s most infamous communications faux pas), we’re even further from normal, both in markets and geopolitically.
Or, actually, it’s hard to say what’s normal and what isn’t. Markets haven’t been allowed to function normally since Lehman. As Deutsche Bank’s Aleksandar Kocic suggested late last year, there’s a sense in which this tightening cycle feels a bit like waking up only so that we can continue to dream again. After all, markets are already pricing the onset of easing, possibly as soon as the back half of next year.
“What we are facing now is the possibility of a moment that interrupts the narratives of administered markets with an episode of ‘normal’ or ‘real’ markets, only to continue later with administered markets,” he wrote, in December. “The market realizes the necessity of rate hikes, but accepts it only as a temporary maneuver in order to save the idea of administered markets — the current acceptance of hawkish monetary policy is simultaneously priced with its subsequent reversal.”
As for humanity, it’s worth reiterating that stability isn’t our natural (or normal) state. Not in the so-called developed world, and not anywhere else either. A testament to that is all that went disastrously wrong during the 1990s and 2000s, a period we typically associate with widespread peace and prosperity. War, disease and famine are just a reversion to the mean.
The Fed’s Black Box magic trick kit makes this recovery illusion into a very challenging puzzle. As they slide around cups, shifting peas around with their slight of hand, it’s impossible to see how they use short term bills to swap out MBS and trade billions in their trillion dollar presentation.
It really is a show designed to influence markets and impact flow, to spook the herd away from a cliff or lead them the opposite direction.
The spreads and curves, inversions and revisions all seem either too slow or too fast as the horses and lemmings stampede. I’m not really buying the signals that say the economy is rocketing and my gut continues to tell me there’s a lot of crap swept under the rug, which at some point, will begin to look like Soviet era beauty contest.
Yardeni blog, Monday:
“Leading Indicators I: Yield-Curve Freak-Out. Everyone is freaking out over the yield curve. That’s because the yield curve is freaking out. The “official” yield-curve spread is the one between the 10-year Treasury bond yield and the federal funds rate (FFR). It tends to be a good leading indicator of both recessions and bear markets in stocks (Fig. 1 and Fig. 2).
In fact, this spread is one of the 10 components of the Index of Leading Economic Indicators (LEI). It has widened from around zero in mid-2020 to 229bps during the March 25 week of this year. It is signaling continued economic growth, as is the LEI, which has been in record-high territory since December through February (Fig. 3). The LEI tends to lead the Index of Coincident Indicators (CEI) by several months.”
The single most irritating thing about the inversions narrative is what I perceive to be market overvaluation.
It strikes me as fairly insane that short term yields are going vertical while stocks are drifting along continually within reach of new highs. It’s like a cross between Greenspan’s conundrum and a supercharged plunge protection team on steroids. And of course, vix continues to not matter for stocks, while municipal bond yields crash and in the background is all that unimportant noise left over from the global pandemic that ended a few weeks ago about the same time Russia attacked Ukraine.
Things are fine, but a few spreads are slightly mixed up and buying the dip has never been more fun.
I have a stock market valuation process that’s telling me stocks are expensive now and it’s pretty obvious that as yields go a lot higher with stocks also going up isn’t compatible over the long-run. In addition to that, personal income per Capita is going down, which adds to the overvaluation case.
With that backdrop, the spread disconnects we’re seeing are probably going to accelerate their mixed messages, which seems like it won’t be a good thing, but, maybe this will be the process by which new highs in stocks will be made? If none of the old metrics matter and if risk is no longer part of financial equations, that means a lot of investors and people at the Fed have a whole new world framework to ponder.
The Occam’s Razor approach would not be to posit the emergence of a new set of financial relationships to explain why stocks will keep going up up up while rates rise, curves invert, liquidity withdraws, growth slows, etc.
It would be to expect that the one proud nail in this board gets hammered down.
Stocks go down. The disconnects connect. All’s right with the world. As long as your thumb wasn’t in the way.
The only way the Fed can get out of this predicament is if Congress spends more. They’ll never run down the balance sheet otherwise. And if they never run it down, the Fed gets stuck in the awkward position of backstopping prices indefinitely… doing exactly the sort of financial incentivizing that’s supposed to be left to the political branch.
Alternatively, you could solve this state of affairs by just leaning into it, and giving the Fed more fine-grained credit regulating authority so they can tackle specific sectoral sources of inflation. e.g., they could directly limit the amount of credit that banks can originate, or match a different rate to each industry. It would return enormous fiscal capacity to where it belongs: Congress. And hey, if price discovery is already dead, why not bury it?
Being stuck in this vague middle-ground between capitalism and a command economy really just means you end up stuck giving the wrong people the handouts.
There are two observations that are always made when yield curves invert. First, that they have a perfect, or near perfect record of predicting recessions. Second, “this cycle” the signal is less relevant. Of course you get encouragement from those who ought to no better. McDonough in 2000 or Bernanke is 2006. Is the US equity market perfectly priced? If over the next 2 years one outcome is a 35% decline (recession) or 10% gain (no recession) and the probability of recession is 35%? It might be.
The potential gain/loss scenario is probably close enough for government work. It will be the change in that perception of the probabilities that will create the chop one should expect in the markets. That and a whole bunch of extraneous stuff should keep everyone on their toes.
I think it is a very interesting time. 2 virtous circles reversed: a 41 year bond market rally, and the return of the cold war(maybe it never left). I think as far as signals, we have basically had the fed continsously suporting financial assets and the mortgage market since 2009, and now we have have a very strong fiscal stimulus too. We now have the much desired infaltion, because the alternative was too terrifying. Stocks are harder to parce, because the passive takeover distorts price discovery as much as the fed and congress. I personally think governments hate deflation, and so do debtors. Sounds like a clusterfuck to me. Add in the desire of very important scumbags: Putin, Xi, the ayatollahs, the Mcmafia to dethrone the dollar. All sounds bearish- however, it doesn’t feel that safe to short equities or buy vol. Risk, uncertainty and ignorance are a bitch. And we haven’t really figured out what the new supply chain should be.