The Elephant in the Room

This week the run of steeper curves and rising long-term rates continued, not only in the US but in all advanced economies. Despite weak January inflation data of last week, market participants are still expecting rising inflation in the years ahead. Though the Federal Reserve does not seem to be too much concerned about inflation, as we could read in their Wednesday released Beige Book. In the meantime, Bitcoin is pushing higher and higher and above 50,000 US-dollar for the first time. Gold stays depressed, maybe because of the rise in yields and the euphoric risk taking of market participants.

US 10y treasury yields rose to new highs, levels that we have not seen for a year and the chart looks very bullish as 10y yields broke out of the upward trend which started in August. Next resistance would be around 1.50 % - 1.60 %.

All advanced economies are experiencing a steeper curve, 10y bund yields also are back above -0.4 %, trading at -0.32 % at the moment. Market participants expect strong economic growth and thus higher inflation on the road. The US 10y breakeven rate is back at 2014 levels:

At some point rising yield should be a problem for stock gains although until now it seems that the stock market did not care about the rise in yields. The Dow Jones Industrial made another all time high on Wednesday this week (31,613.02 points)

My guess is that the rise in yields reflects the rising risk-appetite of investors who dump their safe-haven assets and buy riskier instead. Apart from stocks we can see this in high-risk bonds too: Junk bond yields are at an all-time low and face heavy demand. According to the Financial Times 'more than 15 cents of every dollar raised in the US high-yield bond market has been sold by groups with ratings of triple C or below since the start 2021'. This is the biggest share since 2007:

How long can the rally in stocks continue? One of the main arguments by the bulls is that there is still a lot of cash on the side-lines, ready to buy and to push prices higher because of investors appetite for risk. According to them this should push stocks to all-time highs over and over again.

However, to me it seems that there is FOMO all over the place already, at least a report of BofA, according to FT, says:  

'BofA noted that about 63% of assets under management at its private bank, which serves wealthier clients, was now allocated to stocks - an all-time high'

Market participants are taking risks which they have not taken for 20 years and still are not worried about it. They expect the bull market to continue and do not see market exuberance. According to a BofA survey

'Just 13% say that U.S. stocks are in a bubble, while 53% see a late-stage bull market.'

Market participants fully trust central banks and governments monetary and fiscal policy and that those measures will keep the party going. JP Morgen says that the biggest risk markets are facing is that the Fed will step in too early and tapers to soon if the situation in employment improves and inflation returns in the future.

In my opinion the rise in yields is not over yet, especially because a 'too soon step in' by the Fed is off the table, as we can read in the Feds Beige Book which was published this Wednesday. The participants find that 

'economic conditions were currently far from the Committee’s longer-run goals and that the stance for policy would need to remain accommodative until those goals were achieved'

Further it seems that the Fed is not worried about rising inflation expectations. Federal Reserve of Boston Chair Eric Rosengreen said on Wednesday that he  

'would be very surprised if we see a sustained inflation rate at 2% in the next year or two with labor markets as disrupted as they have been'

Therefore I would expect that monetary policy stays loose for longer, maybe even longer than anticipated by markets. It seems that the Fed is fearing deflation more than a sudden pick up in inflation and thus I conclude that the rise in rates is not over and neither is the bull market in stocks. Because cash-reserves are shrinking (that is what the BofA numbers are telling me) I think that the rise in yields goes hand in hand with rising stocks because investors sell bonds and buy stocks. 'No need to worry', according to them. 

This is in line with my chart analysis which I made in the beginning of this text where I showed the bullish breakout of US 10y yields. But how long will US Treasury rates rise, how long can they rise?

To answer this question I want to share I chart that I came around the other day. The chart is from George Goncalves (thebondstrategist.com) and shows the US 10y yield and the Fed's fund rate

 

The chart starts at the end of the 1980s and shows that 10y yields are in a straight downtrend since then. The upper bound of the trend was reached only four times since 1990 and always only when the Fed has already start to rise rates. 

The upper bound is currently at around 3 %, which is significantly higher than rates are now. Because it was only reached at the near end of a hiking cycle I would expect that 10y yields will find a strong resistance at about 1.5 - 1.6 % because I do not see any circumstance where the Fed would raise rates or start tapering anytime soon after all. 

Also I do not expect very high inflation rates (about 5 % or higher) anytime soon where the Fed may be forced to act (even though I doubt that they will, because it would crush asset prices) or to let inflation run it's course and face another steepening of the curve.

But we know, that in our monetary system it is not the Fed that takes the main part in money creation, it is the commercial banking system. Despite the Fed largely increased base money and very loose credit conditions, credit growth has collapsed since March last year and so did money velocity. 

Nevertheless I think that a gradual pick up in inflation is possible because commodity prices have exploded recently. Andreas Steno Larsen and Martin Enlund from Nordea also expect that as they write in their (highly recommended) FX-weekly.

Andreas and Martin expect higher fuel costs (this effect could be strengthened because of the lates extrem weather events in Texas) which would may cause inflation to rise to 2.5 %.

Further they write that

'And if core inflation starts to move higher based on “unexpected” spill-overs from higher fuel costs - we might get inflation readings around 3% before summer.'

Expected growth rates of around 10 % YoY (which would not be totally surprising given the huge drawdown in 2020) could be a tailwind for inflation and may also cause some price pressures in consumption goods. 

Although I still remain skeptical if the expected big recovery will happen. Although this weeks data about retail sales was beating expectations by a wide margin I would connect this with the new stimulus - or as Charlie Bilello wrote on Twitter:

The boom in Retail Sales resumes with new highs in a January surge. Lesson: if you give the American consumer free money, they will spend it. pic.twitter.com/GlP5eY4UuE

— Charlie Bilello (@charliebilello) February 17, 2021

My expectations are that the economic environment will be difficult into the summer. I am pretty convinced that we will get at least one more round of stimulus by the Biden Administration and if supply chains remain disruptive and fragile, this could also lead to higher inflation on the one hand, but on the other hand lower growth. Lower growth would mean that employment remains tense for longer. As I wrote a few weeks prior, my view is that the stagflationary scenario is the most likeliest one. 

I stick to this even if growth will be in line with expectations because then I would expect credit growth to pick up and velocity as well. This may be an even more dangerous scenario and those stimulus checks pumped lots of money into the real economy which was solely spend instead of invested. Therefore I would expect that growth remains depressed in the years after 2021. 

Of course there are several arguments that there will be no inflation, because we have not seen it after 2008 and I agree that people like Jeff Snider do have a point when they talk about thinks like credit growth, the eurodollar system (which is deflationary) or the big drop in money velocity. But I also think that ongoing stimulus checks to consumers and the instrument of government guaranteed loans will create inflation pressures.

This is why I think that inflation is still the elephant in the room that nobody is seeing or taking seriously, although market participants think that inflation will rise, but what I find, for the wrong reasons. As I understand it, it is that they expect that inflation will rise because of economic growth. However, they neglect that inflation does not necessarily mean strong economic growth. 

I think that the current euphoria and rising rates as a result of rising inflation expectations will continue for a while until a certain point is reached. Then I think that we will see another deflationary shock in asset prices before the elephant will be seen by everyone. Until then, expect more highs to come...

Have a great weekend everyone!
Fabian Wintersberger

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