Rates Markets Surrender to the Fed

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What You Missed: Long-term rates traded much lower as equities traded higher after an unexpected decline in US bond yields. A variety of factors, some fundamental and others technical, contributed to the surprising drop. The yield on the US 10-year Treasury note slipped below 1.30% early in the week before rebounding to 1.34% on Friday. A week ago, it stood at 1.44%. One-month LIBOR and other short-term rates continued to drift near all-time lows. Oil prices held most of their recent gains amid an ongoing OPEC disagreement over production levels, while the US Dollar traded flat and Gold rallied. Treasury yield volatility, a key driver of the cost of rate caps and other option-based interest rate derivatives, rose throughout the week.

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Yield drop caught markets by surprise. We spent much of last week trying to decipher the cause of the recent plunge in Treasury yields. We weren’t alone. Various narratives have been offered but no consensus thesis has emerged. Among the factors cited are increasing concerns over the spread of the Delta variant of the coronavirus, signs that global growth and inflation may have peaked near term, fears of a slowdown in China’s credit growth, and a flatter US yield curve due to the Fed’s inflation vigilance. While many are now recalibrating their interest rate forecasts, you can be sure that it’s a signal that the global recovery may not proceed as smoothly as previously expected.

Our take: Peak reopening optimism this spring meant economic prognosticators – like us – sketched a wide range of potential paths for America’s economic trajectory in 2021, with most eyeing substantial upside. These forecasts came with increasing inflation, and rising interest rates over a two-to-three-year post-pandemic economic recovery timeframe. Markets manifested these views in the wildly popular “recovery trade” where investors bought into sectors of the economy that expected to be positively impacted by the US Treasury’s money printing and the Fed’s low interest rate policy tools.

The recovery trade has now come under threat. The question now is, who or what sullied it? And why? Here’s a short list to make you more interesting at cocktail parties or during the meeting chatter at the start of those dreaded Zoom calls.

  1. Blame the Fed. With the easy-money punchbowl undeniably sweet right now, the Fed’s headfirst dive into bond markets to keep it so distorts fixed income markets. This is especially true in the mortgage-backed securities market, where the Fed, despite the lowest mortgage interest rates in history, continues to buy the securities to keep mortgage rates low. The result is sky high housing prices. This negative feedback loop is now slowing the housing market down. Is the dynamic enough to prompt the dump in Treasury yields last week? Probably not.
  1. It’s the Delta Variant’s fault. COVID-19 continues to find ways to make us sick, as evidenced by a resurgence in infections, best seen in the UK – arguably the most vaccinated developed country and the first to see the Delta variant. The difference between now and when COVID-19 began showing up last year is a much lower rate of hospitalizations and death. Can this be seen as the reason to doubt America’s continued re-opening and reflation, even with Delta variant infections on the rise on this side of the pond? Possibly, but by itself, it’s probably not enough to justify last week’s monstrous yield move.
  1. Could Janet Yellen, and her pesky US Treasury, be the culprit? Maybe. Among other things, the US Treasury issues bonds to fund – or at least try to make a dent in – all these expensive pandemic recovery benefits passed by Congress and the President. You know, things like augmented unemployment benefits and the like. The funds the Treasury received from selling these bonds sit in an account which mushroomed to over $1 trillion last year. Now that light can been seen at the end of the pandemic tunnel, the account is now being run down, with the Treasury now selling fewer bonds to fund it. With the Fed – as part of its stimulus programs – still buying these bonds at the same high clip, bond prices naturally go up while their yields go down. Such an easy explanation. Why didn’t the world see it before last week? Hindsight is 2020 indeed? Let’s look at one more.
  1. It’s Britney’s conservators. We don’t know where you stand on Britney Spear’s conservatorship, but it probably has nothing to do with interest rates or economics. Just putting that out there in case you’re wondering. #FreeBritney
  1. Point the finger at China. Recent economic data out of China implies that its post-pandemic economic recovery has peaked. Given that China was the first into the pandemic biologically and economically, it’s likely they’ll be the first out of it in both respects, and that its already happened. Further, recent weeks have been filled with news of China clamping down on its tech companies, doing its best to squash bitcoin and making life difficult for Tesla in the form of forced vehicle recalls. Taken together, it all implies that China’s economy – which has driven much of the world’s economic growth over the last decade – is slowing down. This implies that America’s post-pandemic growth peak can’t be far behind.

While the specific causes are debatable, all told, last week’s yield dump implies a belief in lower inflation (we tried to tell you) and a less resurgent economy that won’t need the Fed to act to slow things down anytime soon. Fed funds futures markets – which represent the financial market’s opinion of when and how much the Fed will hike or cut rates in the future – started to imply last month that supply chain bottlenecks and pent-up demand behind the growth and price surges will eventually give way to an aging population with corporations and governments struggling to handle their full belly of debt. That implication accelerated last week. On the upside, credit remains resilient, for now.

FOMC minutes set stage for earlier taper. The minutes of the June meeting of the Fed’s Federal Open Market Committee showed that “various” members said they expect the conditions for beginning to taper asset purchases “to be met somewhat earlier than had been anticipated.” The minutes show that inflation has run hotter than members expected, but that it has been concentrated largely in sectors impacted by the economic reopening. Therefore, the current high rate of inflation is temporary but skewed to the upside.

Our take: That was then, in mid-June, but this is now. Since the committee’s meeting, the market has come to expect early rate hikes, but fewer of them than expected before the meeting. Heightened concern about upside inflation risks has peaked – as evidenced by last week’s yield move – a pattern we expect will play out over the course of 2021 and into 2022. That, coupled with what is still a big shortfall in employment when compared to pre-pandemic levels – the Fed’s #1 concern – means a slow walk toward the stimulus exit, and that the Fed is a long way from contemplating rate hikes. As we’ve said previously, the Fed will begin publicly outlining a plan to taper its asset purchases late this year, will commence tapering in early 2022, and will hike rates in early 2023. Until then, expect long-term rates to stay largely range-bound, and muted wage gains and steady declines in goods prices to slowly turn down the heat on the inflation debate.

European Central Bank adopted new policy framework. The European Central Bank (ECB) adopted a new, more flexible policy framework this week that echoes a similar structure implemented by the Fed around a year ago. The ECB shifted its inflation target from close to, but below 2% to a firm 2%, while allowing for periods of overshoot. In contrast, The Fed aims for inflation to average 2% over time, letting inflation run hot for some time to offset periods when it falls below its 2% target.

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As a result of the strategy shift, investors expect the ECB to maintain its exceptionally loose policy stance for even longer. Why you should care: Since US Treasury yields are influenced by their European counterparts, specifically German Treasury yields, the ECB’s move adds yet another drag on US Treasury yields moving notably higher in the near-term.

What to Watch This Week:  A slate of key data lies in wait in the coming days, which will help to narrow the range of possible economic trajectories even further than that seen last week.

As we all suffer from pervasive supply shortages across a range of goods, our propensity to spend, and cash to do so, is merely delayed, not eliminated. Tuesday’s release of the Consumer Price Index – one of the Fed’s favorite gauges of inflation – will evidence even higher prices as a symptom of those bottlenecks, combined with higher energy prices.

Thursday’s industrial production data – specifically the Empire and Philadelphia manufacturing surveys – will give markets a sense of how quickly supply is catching up with demand, and how the trend will play out in Q3.

Elsewhere, Friday’s retail sales data for June will likely show a soft end to the quarter after the sugar high, stimulus-fueled strength in the spring. As consumers’ retail spending on goods slowly rotates toward services in the late summer and fall, we’ll look toward things like restaurant, “out to dinner” sales as a proxy for consumers’ appetite for services spending.

For the Fed, Chair Powell will be front and center on Capitol Hill on Wednesday to kick off two days of testimony on monetary policy and the economy. Though House and Senate lawmakers will voice concern about an uneven recovery for their constituents, Powell won’t deliver any new information outside of what was gleaned in last week’s Fed monetary policy meeting minutes.

Big Picture: If this week’s price inflation data shows even stronger inflation, will it last? Likely not. The boost from reopening and fiscal stimulus will fade into late fall and winter, especially as wage growth, while impressive in some sectors like hospitality and leisure, lags inflation and eventually limits consumers’ purchasing power. In turn, inflation will subside into 2022 as economic growth slows to a more sustainable pace near the end of this year. For now, are the eye-popping inflation numbers impressing you? Be prepared to be equally impressed on the way down next year.

For rates, know that bond yields retain a downside skew during this era of broad and deep stimulus, with or without talk of tapering. Bond purchases by the Fed are set to continue at their current record pace for awhile yet, and the ensuing positive impact in debt prices – and corresponding negative impact on yields – will linger well into the fall at a minimum. COVID variants are spreading, tapering is likely delayed, peak growth has likely past us, inflation looks transitory and there’s still no confirmed size for an infrastructure deal. All are factors that will likely slow a global economic rebound and make central bank stimulus programs last even longer than that expected even a month ago. Are you prepared for this change? Term rates are looking more attractive than they were last week. Contact us to strategize.

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Source: Bloomberg Professional

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Source: Bloomberg Professional