In the week just passed, the Treasury market started with a decidedly bearish tone. This was due in large part to hedging associated with series of large corporate bond offerings. Once those deals flowed through the market, we saw a stabilizing bid occur even before Friday’s flight to quality that was driven by an increase in COVID cases in Europe and the announcement of an Austrian lockdown.
The Long-End Outperform
Lately, even in an environment where inflation is running high, forward inflation expectations are elevated, and the market continues to bring forward Fed rate hikes we have been seeing a contained sell off in tens and thirties, in a different way, the outperformance of the long end of the treasury market.
To some extent, it is the notion that the Fed will bring forward rate hikes contained the sell off in the long end of the curve end since the more aggressive the Fed is compelled to be in tightening monetary policies to offset inflation, the lower one would expect inflation and real economic growth to be going forward. So the disconnect in fact has to do with the divergence of the outright levels of CPI and real GDP versus what we’re seeing in terms of nominal rates in tens and thirties. The logic being that traditional models would suggest that given the amount of inflation that’s going through the system, 10 and 30 year rates should be substantially higher. But we have seen over the course of the last 20 years is an ongoing compression in term premium, and even an environment where inflation is running higher than anticipated, the amount of inflation premium required to go further out in the curve, while higher than it might otherwise have been, still remains contained in historic context. And this does bring into the question below why are ten year yields still below 160 and 30 year yields not even at 2%.
Greenspan’s Conundrum
In the fourth quarter, October’s retail sales data came in well above expectations, both on a headline and control group basis. So once again, this begs the question that if in fact growth is doing okay in an environment when we’re getting such high inflation prints, why are tens and thirties still trading below 160 and 2% respectively?
This could be simply a reflection of not only forward expectations for US growth and inflation to eventually mean revert, but also the idea that treasuries, particularly the 10 and 30 year sector, are a function of global macro influences. Whereas twos, threes, and fives are simply wedded to monetary expectations. The reality is that Greenspan’s conundrum never truly went away. Since the financial crisis of 2008–09, the U.S. Treasury yield curve is as flat as it has been. When asked for the likely cause, I would lean towards that the negative interest rate policy that the ECB and Bank of Japan adopt promotes the need of overseas investors for higher-yielding long-term bonds in the U.S. The strong need has been compressing the term premium, inflation premium and growth premium of the U.S. treasuries, which is in fact a reflection of the slowing down of global economic growth. It could also explain why some are perplexed that such a flattening has historically been a late cycle development, not what one would expect when the Fed has yet to follow through with the first rate hike. I mean it is a late cycle development, just not for the U.S., but globally.
Fed’s New Framework
This trend is also consistent with the increase in central banking transparency that has occurred and as we have learned over the course of 2021, the Fed has been and will continue to be unwilling to risk decades of hard credibility as an inflation fighter during one cycle. Now, this does bring into question how committed the Fed is to their new framework, recall that in 2020, the Fed introduced this average inflation targeting notion as well as maximum versus full employment. All of which implied, that the Fed wouldn’t respond to inflation in the same way that they had in the past. What we have seen in 2021, is that investors to a large extent have lost faith in the Fed’s commitment to the new framework. Now I’ll argue that’s not necessarily fair, simply because the magnitude of the upside surprises on the inflation front had put Powell in a very difficult situation. Even if the Fed did want to allow inflation to run hotter than it has in prior cycles, the US economy is simply faced with too much inflation at the moment for the Fed to stand idly by.
The Nod for the Big Job
And another defining feature of the market narrative this week was uncertainty about who it ultimately will be that president Biden nominates for the Fed chair seat. The baseline assumption remains that there’s a higher probability that Powell gets the official nod since this is the path with the least resistance. The second most likely candidate will be Brainard. Some of the recent price action confirms the notion that Brainard would be interpreted as a more dovish outcome for the FOMC. But regardless of whether or not Powell or Brainard ultimately get the nod for the big job on the FOMC, it’s certainly likely that whoever is nominated will lean more dovishly. After all, let’s not forget, the midterms are going to be quickly approaching and for any presidential administration that would like to perform well at the polls, having an easier monetary policy bias and a title labor market would obviously be a benefit.
All About Macros 