Oct 30. Seven years of college [or CB policy], down the drain
Flounder: Will that work?
Otter: Hey, it’s gotta work better than the truth.
Pretty much sums up the election cycle. (youtube link at bottom- Animal House)
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Yields jumped last week and the curve steepened to new recent highs. First, a couple of curve notes. The red/gold euro$ pack spread which I highlighted a couple of weeks ago has surged 20 bps since the end of September, from 41 to 61, now the highest since late June. Although the magnitude of the move wasn’t quite as large, the 2/10 treasury spread over the same time frame rose from 81 to 99, and importantly has exceeded June’s high (associated with Brexit). Speaking of Brexit, the 10 year Gilt has risen from a post-Brexit low of 52 bps made in August, to 126 now. So the yield has more than doubled in two months. The German bund was -14.5 in late September and is now on the right side of the grass at +16.7. The US ten year has gone from 156 to 185 in the same time frame. It’s also interesting to note that the high in the Russell 2000 stock index was made in late September at 1263; it has since formed a top and closed at 1188 Friday, a loss of 6% in a bit over a month. (Initial objective 1150-55).
There is a powerful bias for rates to remain low and curves flat, having to do with demographics and huge debt loads. For example, from Hoisington’s last missive, “As an economy becomes more over-indebted, additional government spending slows growth even more due to ‘non- interest economic costs’ such as misallocation of saving, reduced productive investment, weaker productivity growth and eventually a deterioration in demographics. Slower growth will cause underutilized resources to build, bringing down inflation and subsequently interest rates. Therefore, increasing deficits have, and will continue to result in lower, not higher, interest rates.” This quote is typical: “Rates are going to remain low for the rest of my career,” Memani, 56, said Friday in an interview on Bloomberg Television. “And I am looking forward to having a long career.”
On Friday there were indications that selling pressure was abating. For example, the stronger than expected Q3 GDP of 2.9 caused initial selling in rate futures, which was easily absorbed. The FBI re-opening of the Clinton email saga late in the day further raised uncertainty and lifted fixed income contracts. For example, EDZ8 made a new low for the move, had an outside day and closed higher. However, that wasn’t the pattern for all contracts.
The long term question is whether this rise in yields is a change in trend or not. The more immediate issue is, could this be the start of a ‘taper tantrum’ type move? Recall that in Q1 of 2013 the US ten year yield was right about where it is now, 1.80 to 2%. It dipped going into Q2 then ripped higher in June, hitting 3% by the end of Q3. In terms of where yields ‘should’ be, there’s this from Martin Feldstein: “The price of the 30-year Treasury bond is so high that it implies a yield of about 2.3% [actually 2.6 by the end of the week]; given current inflation expectations, the yield should be about twice as high.” (from a Project Syndicate blog, link below). Whether this is a long term change in trend or not, it’s certainly advisable to sidestep what could be a large back-up in yields. I have previously shown that oil prices are closely related to forward inflation expectations, and while crude had a reasonably sharp drop this week, the pattern since August is one of higher highs and higher lows. As a side note, copper had a strong rally this week, jumping from 209 to over 219.
I would further mention strong corporate issuance. “Companies including yogurt-maker Danone SA and Honeywell International Inc. sold about $62 billion of bonds worldwide this week, the most since mid-September, according to data compiled by Bloomberg.” These are pretty large numbers, (global corporate bond issuance is over $2T this year), and CBO projections of increased US deficits are going to add to supply. However, the largest factor regarding yields and curves is perceptions of central bank actions. The withdrawal of QE and the idea that rate repression has run its course could lead to large global rate re-sets. This dynamic could simultaneously be responsible for declines in other financial asset prices. The fraying typically begins at the edges, and I would use weakness in the Russell 2000 as a prime example. Although HYG and JNK junk bond etfs made new ytd highs on Monday, I received this interesting chart showing record outflows from HYG (thanks AOK).
While some would point to potential Fed rate increases as the main culprit for current price action, note that January Fed Funds made a new low this week, printing 9940.5, indicating around 80% of a hike already priced for December. However, FFF7 settled 9942.5, down only 0.5 on the week. All near euro$ one-year calendar spreads are within a few bps of 20, so forward rate hikes are certainly expected to be gradual. This isn’t about the Fed all of a sudden getting rate hike religion, it’s about a lack of confidence, increased uncertainty, and building in an inflation premium. These factors are difficult to quantify…it’s best to take technical cues from the way the market trades.
Another issue which goes into the ‘difficult to quantify’ basket is China. I saw a couple of notes this weekend citing a surge in China’s one year swap spread to 52 bps, from around 5 at the end of June, the widest since July of 2015, with the one-year swap at 273 bps. (ZH, link below). Doug Noland notes that “Chinese 10-year yields traded Monday at a record low 2.60%. There seems to be a safe haven dynamic at work.” Tightening financial conditions in China could spill over into other markets; again, it’s probably best to take technical cues from the market rather than be swayed by divergent fundamental data sprinkled with political ‘bombshells’.
Having said that, this is a big week for possible catalysts in the US, including ISM mfg and service data on Tuesday and Thursday, the FOMC meeting (no press conference) on Wednesday, and Unemployment on Friday.
