While stocks have been a (mostly) one-way ticket higher, 2021 has been a rollercoaster for interest rates: after 10 year yields rose +83bps in Q1, they fell -27bps in Q2 and have started Q3 by already falling another -12bps.
So yesterday, when commenting on the latest violent move in yields lower which left a majority of rates traders (who have been blindsided by the move) speechless, we quoted JPM's rates strategist Jay Berry who said that "the 10+bps decline in 10-year yields since Friday morning seems outsized all considered" and added that 10-year Treasury yields was 25bps too low relative to model-implied fair value, a 3-standard deviation divergence, and the largest such deviation since the early fall 2020.
To be sure, one argument that has been floating around is that extremely bearish 10Y positioning has been the main cause behind the ramp, as the recent move became reinforcing once weak-handed shorts were squeezed and rushed to cover, with JPM conceding as much, noting that "position technicals are exaggerating the moves in Treasury yields as of late: our weekly Treasury Client Survey has remained short relative to average levels over the last year."
On the other hand, one can also point to fundamental factors as causing the move, with growing fears of a global slowdown amid a resurgence in global covid cases (magnified by yesterday's news that China is preparing for one or more rate cuts as it seeks to kickstart its slowing economy) depressing 30Y breakeven rates.
This closely watched proxy for annual inflation expected over the next three decades, is about 2.18%, its lowest since March after being as high as 2.41% in May, with investors far less inclined to hold reflation wagers across asset classes. Indeed, Bloomberg notes that breakevens in all maturities are down from last week.
So which is it - technicals or fundamentals, or is it something else? As it turns out, the question what is behind the sharp bond move is what everyone on Wall Street wants answered, as the latest flash poll from Deutsche Bank credit strategist Jim Reid demonstrates. In it, he asked readers to score from 0 (no impact) to 10 (extreme impact) the influence of four factors on the recent aggressive rally in US yields including:
i) concerns over reverting to medium to long-term secular stagnation (low growth, low inflation);
ii) The delta variant and ongoing covid concerns;
iii) Supply/demand technicals in the bond market and
iv) the FOMC pivot
As Reid writes in his Daily note today, "collectively you believe that supply and demand technicals in the bond market are the main driver by a reasonable margin but that secular stagnation type fears were next most influential. The FOMC pivot and the delta variant are seen as slightly less important."
For his part, Reid says that he believes technicals as the most important variable:
"I have sympathies with the secular stagnation (or maybe stagflation) argument medium-term but I think there is likely to be a continuation of the strong cyclical rebound over the coming quarters. I think it’s too early to price the medium-term issues."
One reason why Reid thinks technicals are behind the recent outlier move is a result of the "extremely rare" confluence of supply and demand in the rates market, where in a previous note, the DB strategist found that on a rolling 3-month basis the entire net supply of treasuries had recently been taken down by the Fed on a net basis. Compounding the technical picture, the move has occurred in a period of exceptionally strong demand from banks and foreigners. Near-term supply demand dynamics are summarized in the following chart from Reid's DB colleague, Steven Zang, who shows treasury net issuance and Fed purchases in the coming months.
Concluding that "more normal service" should resume in the supply and demand for Treasuries from August, Reid is confident that we may have some clues in a few weeks as to whether the technicals were the main source of blame or whether something more sinister is occurring.
Surprisingly, one strategist who disagrees with Reid that the Treasury move is driven by technicals is his Deutsche co-worker, George Saravelos.
Pointing to the "truly remarkable moves" in fixed income "which continue having knock-on impacts on broader markets, including persistent strength in the dollar", Deutsche Bank's global co-head of FX Research disagrees that rates move is technically-driven and instead reverts to an argument he presented last month, namely that r* (or the neutral rate of interest at which an economy can sustain full employment without overheating or contracting) is now so low that any attempt to tighten will automatically push the economy into recession. This explains the bizarro response to the Fed's tightening expectations, which resulted in a deflationary counter-tantrum, with yields tumbling and one which Saravelos said "boils down to a very pessimistic market view on r*" (see "Powell Just Made A Huge Error: What The Market's Shocking Response Means For The Fed's Endgame").
This is what Saravelos said:
The market initially attempted to explain the moves via technical drivers and commentary has now shifted to a near-term growth scare. We disagree with both explanations. We think the single most important driver of the moves are persistent and rising global excess savings as well as a pessimistic reassessment of medium-term trend growth encapsulated in low real neutral rates, or r*... it ultimately boils down to the medium-term scarring effects of COVID on the global economy. The market is being forced to consider this as it transitions from the focus on the near-term cyclical drivers (the so called "gangbusters" narrative) to the new economic steady-state post the initial v-phase of the recovery. This transition is marked by three powerful shifts compared to the drivers of the first half of the year.
Saravelos offers three explanations for how we got to this point:
Saravelos offers three reasons:
A big turn in global fiscal policy. The first half of the year was marked by an unprecedented mix of pro-cyclical fiscal and monetary policy just as the economy was taking off. However, this fiscal support was a one-off money transfer. The income boost to households via temporary VAT cuts, expanded unemployment insurance, one-off paychecks is now expiring across the globe. Because all this support was temporary, growth has to now be much more reliant on private rather than public sector spending.
A big turn in vaccine efficacy. Recently DB argued that the Delta variant puts herd immunity out of reach. This is a critical turn from the vaccine optimism of the first half of the year because it implies recurring COVID waves may be a persistent problem going into the winter months. Even if hospitalization is lower these waves could have a more persistent impact on spending patterns especially in those economies where vaccination rates are too low (many EMs) or are stalling (France and the US).
The end of the V: A big part of the growth recovery in H1 has simply been a return of activity to more "normal" levels via the easing of stay at home orders. But growth going forward now has to rely on recurring, rather than catch-up demand. What is more, it has to increasingly rotate towards services where the evidence on persistent pent-up demand recoveries is empirically weaker. In sum, the move from the 90% to 99% economy was easy, growth beyond will be more difficult.
As for how a record low r* impacts pricing, Saravelos explains that in a low r* world elevated bond and equity prices are entirely consistent - they are both reflective of a private-sector preference of excess saving over consumption. It also indicates something truly ugly: that the market is not pricing a near-term growth scare but persistent secular stagnation, equally visible in the very large compositional rotation of equity performance from cyclical to growth stocks akin to 2010-2019. As for the market, it is pricing a Fed reaction function that is "too responsive" to near-term bottleneck pressures but that will ultimately not be able to go very far if it hikes rates, according to the DB strategist.
A somewhat less gloomy take comes from Gavekal's Louis Gave who has listed 4 macro scenarios going forward, as noted by Bloomberg's John Authers:
The world does not reopen fully and supply chain disruptions persist. Against this backdrop, governments continue to spend massive sums (printed by central banks). Aggregate demand continues to outstrip aggregate supply and so inflation proves more resilient than central banks, or the markets, currently expect. The probability of this scenario is significant.
The world reopens fully as vaccines and improved treatments reduce hospitalization and mortality rates even though infections may rise again. Demand surges on the back of strong consumption and a rebound in capital spending. The world faces a textbook case of twin demand both for consumption goods and for the capital goods to produce the consumption goods. Inflation remains high as supply struggles to keep up with roaring demand. Currently, this appears to be the most likely scenario.
Even though the world does not fully open again, governments pull back on the massive stimulus they have promised. Demand disappoints, putting prices under pressure. Inflation rolls over. This is the scenario that the market has started to price in over the past few weeks following the US Federal Reserve’s guidance, the scaling-back of President Joe Biden’s stimulus plans, and … the growing perception that [various central banks will soon start to tighten].
Governments continue to stimulate. But as the world reopens, supply catches up and overtakes rising demand. Of all these scenarios, this is the least likely, if only because of the dearth of capital spending over the last year and the rise in protectionism.
Another possible explanation for the plunge in yields comes from Strategas' Jason Trennert who lists the following five reasons for the drop in rates:
relative bond yields;
faith in the Fed;
expectations that the economic pain from the pandemic is far from over; or
distortions in the reverse repo market resulting in a run on Treasuries. In sooth, we know we don’t know, but we’re still expecting higher yields.
A far more ominous take comes from Robert Griffiths strategist Robert Griffth, who without stating it, suggests that the market is starting to price in outright stagflation:
Probably the most telling part of [Tuesday’s] ISM services release (which fell short of expectations, and drove a fresh leg lower in yields) was the following quotation from one respondent: "Some locations cannot open for business or (have) limited hours, as we cannot staff the restaurant to meet consumer demand.” The number of people in work in the US is still 7.5m below its 2019 peak: you can always find workers, you just have to pay them enough. But for now, companies would rather cut output and stop operating than pay what is necessary to open up their businesses, perhaps because at the marginal wage required to open, they simply wouldn’t make any money.
Of course, one can argue that this is a new steady-state, but the flipside argument is that employers are merely waiting until September when the government's handouts end and the labor market returns to normal, with millions of potential workers joining the labor force in pursuit of any paycheck - now that generous benefits have run out - at which point much of the supply bottlenecks will normalize without a stagflation (despite the Biden administration's apparent desire to cripple the US economy).
But even a September normalization would take months, and in the meantime firms either have to push up wages to satisfy demand, driving a potential inflationary spiral, or hold back on expectation that conditions will normalize, further depressing economic output and sparking even more deflationary fears.
As Authers correctly concludes, "either outcome leads to an economic mess that persists well into next year at least." It is this mess that the bond market is currently trying to sift through and make some sense of what the economy would look like on the other side...Tyler Durden Thu, 07/08/2021 - 15:14