Inversions And Reversions
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)
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.