Back To Normal?
After yields have traded within a range for a couple of weeks now, one could observe a rise in demand for government bonds (US & Europe) this week and, vice versa, a fall in yields.
German 10y Bund yields are back below -.30 % at April levels. Within the current week, 10y Bund yields have fallen more than 10 bps.
Bund yields follow the move of US rates, where US 10y Treasury yields are down nearly 20 bps since July 1st. A possible potential bull flag has dissolved on the downside.
In the stock market, the fall in yields has led to a rotation back into growth stocks, away from value stocks. Especially tech companies benefited from a fall in yields on the long end of the curve. If one looks at the Nasdaq-100 (100 biggest companies on the Nasdaq) and the Dow Jones Industrial Average, one sees that growth stocks have been under pressure because of the fast rise in yields since the beginning of the year.
As yields have fallen, expected (high) future profits of tech companies become more valuable today, their present value rises, thus tech stocks go up in price.
The recent fall in yields could be explained in a way, that the market is not looking at rising inflation numbers, where prices for consumers and producers have risen extraordinary high, but instead is looking further ahead. As we all know, markets are forward looking...
A majority of market participants, financial journalists and economists see inflation as some kind of byproduct of economic growth. Therefore, economic data and forward looking manager surveys have an impact on inflation expectations.
If the economic expansion is slowing, as it seems to be the case, market participants expect lower rates of inflation in the future. The causes, however, are different in the United States and Europe: Since the beginning of this year, the United States have reopened its' economy under continuing fiscal support, which has led to an economic expansion (or a return to pre-covid levels). The reflation-trade seems to be over now, as economic data comes in weaker than expected for some weeks now.
In Europe, the situation is somewhat different. Europe has reopened the economy slowly and -different than the US - only in late spring. However, the rise in Covid cases due to the new Delta variant has led to worries that another round of restrictions may follow to the latest re-openings, which may stifle the economic uptrend again.
Market participants may have anticipated some of this developments back in March, when US 10y yields reached their current year highs. Later this year, in May, US 5y5y Forward Breakeven rates have reached its' year-highs at about 2.4 % and retraced from there.
Although the fall in treasury yields could have something to do more with statements from Jay Powell and other Fed members than with weak economic data (which only proves the Fed's statements to be correct, at least in the opinion of market participants). The Fed is telling markets for months now that they should not worry about higher inflation because this is - according to the Fed - mainly due to base effects and supply and demand imbalances and thus be transitory.
Apparently, bond traders still fully trust the Fed and believe the narrative that Powell and his comrades are telling them about transitory inflation. As the bond market has been right about inflation for the last decade, it is widely expected that it will be right again and the transitory inflation narrative will be proven correct and thus the claim of the Fed is true.
Another point is that the current fall in yields could be the result of a little short-squeeze, as traders close their short positions in the US and European treasury market and as a result bid up the price even further.
Last months inflation fears have already disappeared and the worry about an economic slowdown has taken their place. The end of extra unemployment benefits in the US, which have been in place since March 2020, in order to support the recovery in the job market may also play another role here.
Additionally, analysts and economists point to the recent developments in commodity markets, where prices are crashing back down after they have exploded since the beginning of the year. For example, the price for lumber is down 50 % from it's year highs.
On the contrary, lumber prices play no role when it comes to CPI-numbers. The recent pick up in the CPI has been mainly caused by a big price increase for used cars, because of more demand due to supply chain bottlenecks in the automobile industry. However, everyone expects this problem to fade out as supply chains recover.
We will see if the prices of other commodities follow the lumber or copper example and the situation on the market will ease again. Nevertheless, the bond market expects, that this will be the case.
What contradicts this view is the latest price development in the energy sector, at least a big part of CPI measurement. WTI Crude Oil have risen for a while now and the latest non-agreement by the OPEC states have pushed the price back up to levels not seen since 2014. Thus, I expect that oil prices will rise further, at least above 90 dollars/barrel, within the next months.
Additionally to the end of extra-unemployment benefits in the US, the suspension of rent payments (eviction moratorium) and mortgage forbearance ended last month.
As a result, rentiers may start to raise rents and thus this could lead to an end of weak price increases of rents as measured in the US CPI (It could, but it does not have to, as this part of the CPI is calculated by polls where home owners are asked for the price at which they would rent out the homes where they live in). The following chart is from Mikael Sarwe and the Nordea crew and shows the divergence and that CPI rent of shelter may surprise upwards in the coming months.
However, let me get back to the recent fall in treasury yields. As I have mentioned in a previous text, stronger demand for pristine collateral, basically rising demand for US-treasuries (and/or MBS), is deflationary.
If one wants to get a picture, how strong the demand for collateral is, one only has to look at the Reverse Repo market. Markets participants have parked nearly one trillion dollar of liquidity in exchange for collateral at the Fed a few days ago. A widespread argument, why this is the case, is that the banks have so much liquidity and therefore the Fed has to step in to withdraw this excessive amount liquidity from the market.
So, the Fed is buying US treasuries and MBS (QE) during the day to give it back to market participants at the end of it, paying them a 5 bp yield (instead of previous 0 bps).
The reason, why the Fed is doing this, is that the Federal Reserve wants a floor on the rate of interest, because if it is possible to park cash for x bps at the Fed, other market participants will do it alike.
If the demand for pristine collateral is rising and the Fed has to offer them, maybe the value of this collateral have been rising in the secondary market as well and thus leads to rising bond prices or a fall in yield, vice versa. So, this may also play a role in the current rise in yields.
However, the claim that it is the banks who park excessive liquidity at the Fed makes not very much sense, as the banks have a direct account at the Fed where they can park bank reserves for an interest of 15 bps. Maybe it is not the banks who are parking liquidity at the Fed, but other market participants, Money Market Funds, like pension funds for example.
If one observes the data, one will see that this is exactly what is happening. MMFs are the vast majority of actors in the Reverse Repo Market.
That MMFs do not want to let their liquidity in their bank account, but exchange it with the Fed for the collateral, may hint that they want to play it safe due to the end of extra-unemployment benefits, mortgage forbearance and the eviction moratorium. Instead of letting the cash on their accounts with the commercial banks, they park it at the Federal Reserve (MMFs do not have a direct account with the Fed), the Lender of Last Resort who can always print dollars.
That is why I think that the recent fall in yields may have two components: On the one hand the expectation, that the Fed is right and that inflation will be transitory, and thus is buying bonds, and on the other hand a (possible anticipation) of a coming deflationary shock.
Where I disagree with most market participants is, that this asset price deflation will automatically lead to consumer price deflation. While in fact we do not differ that much about the final result of all this, the disagreement is in how this will play out.
I do not think that the majority of market participants is seeing a fall in asset markets, even though I am sure it will come at some point. However, I am not convinced that inflation will fall back to pre-crisis levels as the Deflationistas are saying. Broad money supply growth has been extraordinary recently and thus I would suspect a peak in inflation numbers in the coming months, but that inflation will stick at a higher rate.
If the fiscal spending of the Biden administration does not lead to the expected results, one should expect more fiscal spending instead of less, as some people are expecting.
In the end it will depend on how harsh the correction in asset prices will be and how the next price shock will affect consumer prices. The worst case then would be a scenario where asset prices collapse and, as the money is pouring into the real economy, consumer prices start to explode.
Just because money stayed within financial markets is no guarantee that this will be the case next time. However, in the end it will depend on the actions of market participants, on human action. That is why it is so difficult to make predictions, especially in economics.
For now, it is time to pause and to enjoy the summer. The next post will appear on August 27th.
I wish you all a great weekend and a terrific summer!
Fabian Wintersberger
Disclaimer: This is a personal blog. Any views or opinions represented in this blog are personal and belong solely to the blog owner and do not represent those of people, institutions or organizations that the owner may or may not be associated with in professional or personal capacity.
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