I think it's entirely fair to say that the future direction of Treasury (NYSEARCA:TLT) yields is the most talked about topic across markets.
To rates strategists and junkies like myself (hell, for all you know I am a rates strategist), it probably always seems like the fate of the world hangs on a few basis points.
That's obviously not the case, but it's certainly true that what happens in rates doesn't stay in rates by any stretch of the imagination. Indeed, out of the three components that comprise what I've called the "reflation trinity," perhaps the most important is yields. Followed of course by the U.S. dollar and stocks.
I've argued vehemently that, at some point (and I don't pretend to know whether it's tomorrow or six months from now), we'll get panic selling in the 10-yr with yields topping 3%. If that happens, you can expect a violent move lower in equities based on historical shifts in correlations around large Treasury drawdowns:
(Chart: Goldman, my additions)
But outside of that (i.e. a tail event notwithstanding), there's likely to be a push-pull dynamic on yields that the Fed will be forced to deftly negotiate or risk throwing markets into turmoil.
On one side is the roll-off of the SOMA portfolio (i.e. no more reinvesting the proceeds from maturing bonds on the balance sheet), inflation, fiscal stimulus, and the divergence of Fed policy versus ECB/BoJ policy. On the other side, are low DM rates outside the US (i.e. low bund and JGB yields), falling velocity of money, and the risk that a geopolitical event triggers a sudden flight to safety.
The x-factor(s) in all of this are rate hikes. That is, the Fed can push back against upward pressure on yields by keeping the pace of hikes gradual. Or, the committee can push back against an overheating economy by raising rates to cool things off.
As for the maturing assets on the Fed's balance sheet, here's a quick summary from Goldman (my highlights):
At the moment, the Fed fully reinvests principal payments into Treasuries and agency MBS, and we still expect this to continue until the middle of 2018. The committee could decide to end full reinvestment sooner due to (1) unexpectedly strong growth, (2) concern about excessive dollar appreciation, and/or (3) a desire to ensure a smooth transition to the next Fed Chair. However, we would expect the FOMC to proceed cautiously after 2013's "taper tantrum", and it may need to consider how its actions intersect with debt management and regulatory goals.
The following chart shows how the Fed has continually reinvested the proceeds from maturing assets...
...and here's a table summarizing recent Fedspeak regarding the timing of balance sheet reduction:
The Fed has to consider the fact that allowing some of these assets to roll off will exert upward pressure on yields. In other words, at a certain point, the rolloffs amount to rate hikes. That's one argument for ensuring that the pace of future hikes remains gradual.
Another argument for not getting too carried away (i.e. too hawkish) is that an overzealous Fed could end up undercutting fiscal stimulus. "We think that the net fiscal expansion would need to be large, as fiscal multipliers, at this late stage of the business cycle, tend to decline fairly quickly over time likely due to aggressive Fed response." Barclays wrote earlier this month, in a note that accompanied the following two charts:
So how will the Fed react and what does that mean for rates? Well it's obviously impossible to know ahead of time, but here are a few excerpts from a Deutsche Bank piece out Sunday that help to shed some light on everything said above (my highlights):
Our bearish steepening view was reinforced by Fed Chair Yellen's remarks earlier this week. After a few other FOMC participants had recently expressed their preference for ending reinvestments sooner rather than later, Yellen noted that the extent to which the Fed's balance sheet has been suppressing yields is likely to decline. This effect, according to the Fed, will be worth about a 15bp increase in 10Y yields in 2017 (via an increase in the term premium), which in turn is equivalent to about two 25bp fed funds rate hikes. She argued that the tightening effect of decreases in the average maturity of the SOMA portfolio and the impending end of reinvestments suggests the Fed should raise rates cautiously.
Yellen confirmed what many other Fed officials have suggested - that balance sheet tapering will be a key aspect of the tightening cycle. This policy stance is at the core of our view. On the one hand, we expect the Fed to remain dovish in terms of fed funds rate hikes, allowing the incoming administration's fiscal stimulus a chance to have the desired effect on the economy, in particular allowing inflation to overshoot in order to avoid short-circuiting the business cycle. On the other hand, we think the Fed will contribute to the ongoing G3 QE taper by cutting its balance sheet (negative QE). This combination of gradual rate hikes and balance sheet cuts strongly favors bearish steepening.
That's pretty clear. Deutsche's argument is that the curve will steepen on the back of a SOMA runoff, but at the same time, the Fed won't get too carried away with rate hikes precisely because i) the balance sheet shrinkage will itself amounts to tightening, and ii) the committee will want to avoid doing exactly what Barclays warned about in the piece cited above (i.e. blunting the effect of fiscal stimulus).
So that's all very interesting, but I think perhaps the more intriguing question is this: what happens if we get a political tail event (like say a Marine Le Pen victory in French elections) in the meantime?
What would it mean for the enormous Treasury short if we get a sudden flight to safety bid? Would short covering drive a huge rally? If so, what would that do to the Fed's calculus?
I don't know the answers, but what I do know ( I wrote a separate piece about this) is that, according to Deutsche Bank's research, the extreme positioning in Treasuries is a contrarian indicator. Have a look at the following scatter plot which shows just how accurate of a contrarian signal positioning has sent over the years:
(Chart: Deutsche Bank)
And remember, it very well could be (and this is somewhat counterintuitive) that your chances of doing just as well as the pros in terms of figuring out how to trade this have risen with the number of variables that have to be considered.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.