APRIL 21, 2021
We take a sightly different tack to writing about the bond market this month. Everyone who has not been under a rock since early January knew that the Biden administration, with a compliant Fed and Treasury will create debt in extraordinary amounts to try and kickstart the US economy. The humongous amount of liquidity created sparked fears of a sharp upsurge in inflation. Bond yields correspondingly responded to that surge in inflation expectations, and have been driven significantly higher. The 10yr yield was 0.9170 on January 2; it has been to as high as 1.75 on March 31.
It looks like the massive reflation effort is paying off and we have been seeing some very significant growth is many economic variables recently. The latest of such notable data included upside surprises Thursday week in the Empire and Philly Fed, a 193K drop in initial claims vs expectations of a 44K decline and a strong beat in terms of headline retail sales which jumped 9.8% m/m in Mar vs. 5.8% expected.
That would have normally (for what has been normal since January) ignited another round of bond yield rally (and sharp drop in bond price). But it was different this time around. Bond traders are still amazed at the shocking bond market response to Thursday's blockbuster economic data – bond yields dropped significantly. The bond market reaction function has changed 180 degrees; the paradigm has changed. Good news has become bad news for bonds.
Some traders discount the “change in paradigm” theme and point to the successful bond auctions earlier in the week and published central bank buying of Treasuries. But the market had been quiet after the auctions, and in fact have been fairly stable even in the light of geopolitical concerns such as are brewing in the Ukraine and Taiwan.
More importantly, it’s the timing – which coincided with the blow out number released on Thursday. The situation is clear – the bond market is now starting to frontrun the likely monetary and fiscal policy changes vibrant economic growth bring. Thursday’s stellar economic reports have been seen by the market as reducing the odds of aggressive fiscal and monetary stimuli in the longer-term.
Bond yields are now not simply being impacted by the outlook for growth and inflation, but also by a reassessment of future policy mix – that is, lower odds of fiscal stimulus strengthening expectations that monetary policy remains at extraordinarily easy settings, which the Fed promised to hold steady until 2023. But they have not made an implicit promise for the QE securities purchases – that’s the new focal point for markets.
In reassessing this change in paradigm, bad news will then become good news from fiscal stimulus point of view, and bond yields should rally. That situation implies as increasing the odds of fiscal stimulus which is a negative both from the perspective of higher securities supply, and from the inflationary impact of more government spending. Good news, on the other hand, does exactly the reverse.
It is not as if the decline in yields was happening as a one-off event. We have been tracking the underlying data which prime move bond yields, and have noticed the increased probability that we may have, indeed, seen a top of the yield rally at 1.75% on March 31.
What the prime mover data show is that the market has crossed a point where even stronger economic data may depress yields further. There is evidence that the bond market is not only pricing the end of the current stimulus cycle, but the lack or dearth of stimulus in the next one.
We will present our case for the bond yield rally having peaked, or it we missed out on the high-frequency timing, a top should be made very soon. To keep the narrative flowing we will present it in presentation style.
The shrinking delta (difference) between Debt Issuance and SOMA means declining net systemic liquidity, which tends to depress long bond yields (see chart above). “A net increase in government debt supply leads to higher yields for all government bonds, due to dealers' limited risk-bearing capacity and a certain degree of market segmentation. A natural implication of their study is that all bonds become riskier when debt supply is large (Gao, Jin, Thompson).”
The inverse is also true, that is, a net decrease in debt supply, lead to lower bond yields.
The Federal Reserve has a massive market rate reduction effect through its bond buying program, and even when the Fed eventually tapers its purchases, it has still taken a huge chunk of the available securities away from investors, maintaining downward pressure on rates.
This filters all the way down to real space through both crowding out and the need to price in a sensible implied inflation breakeven. It does not help that the Fed has been buying up to 25% of the outstanding TIPs issuance, and that has directly pushed breakeven rates higher than normal. But the Fed said that they will start reducing those TIPs purchases.
GDP growth leads changes in Core CPI by 7 quarters; base effects push Core CPI higher till Oct - Dec, then plunges during H1 2021 (see chart above). The long lag between Core CPI and GDP growth has been documented by several prominent bond investors, including Geoffrey Gundlach.
YoY growth in Debt Issuance (w/c leads GDP growth by 1 yr) peaks in May 2021, and could be significantly lower by H1 2022.The Fed's favored 5Yr-5Yr Swap compensation rate peaks w/in a few weeks (May 2021). The inflation mania should therefore peak within a few weeks. The Fed's favored 5Yr-5Yr Infl swap compensation rate peaks within a few weeks (during Q2 2020).
That means current levels of long bond yields have no leg to stand on, and should decline sharply. Bond yields will tend to fall until Q4 2021.
Another theory is the spurt we are seeing in inflation and growth just takes us back to where we were and makes no guarantee on the future. There is a perfect storm here where price falls happened practically bang on a year versus price rises, making the inflation spurt look exaggerated. And if the aforementioned hotel room prices simply return to their previous state and then stay there, well, then there is, in fact, no inflation. This is the “base effect” (see chart above).
The ongoing Treasury General Account (Treasury Cash Balance) ongoing drawdown means there will be less debt issuance needed in Q2 2021 (see chart above).
The TGA balances will have fall below $500 billion by the end of June 2021 -- there is a lagged effect, so the long bond yield may fall until July 2021 at least, from this model.
Smaller debt issuance equates to small TGA balances, which redounds to lower 10Yr yield -- in other words, tighter liquidity is forthcoming, and so the long bond yield should fall.
The process of devolution from ultra-loose regime to a tighter one is hastened by massive impounding of term (money) market liquidity at the Fed’s O/N Reverse Repo (RRP) facility (see chart above). At some point, the Fed may uncap the limits recently imposed on RRP counterparties to accommodate the flood of reserves created by, and emanating from, forever QE and forever fiscal stimulus.
The O/N RRP facility has also been sopping up the liquidity flowing out of the Treasury General Account (Treasury Cash Balance). The TGA has to be reduced to $500 Bilion or less by end of June. TGA flows to RRP facility counteracts liquidity inflows, which tightens systemic liquidity. Funds flowing into the RPP facility reduces the quantity of reserve balances in the banking system, which undercuts equities, push long-term yields lower.
Central Banks ("official institutions") started buying US Treasuries in earnest; that continues until August at least.
The black line in the chart above is the modeled bond buying behavior of foreign central banks which was derived from the TIC data.Not particularly hard to do -- the primary factors are yield change rate and level of the US Dollar.These bureaucrats have a set formula -- has not changed for 30 yrs. And they have started buying, and will be buying more Treasuries hand over fist very soon.
There is, indeed, a remarkable demand for bonds, all the way from US Treasury auctions that were snapped up last week to primary deals right out the credit curve that get gobbled up on a routine basis. This is partly a consequence of the Fed pitching front-end rates at zero and the generation of excess liquidity. Cash has to go somewhere, and it can't all go into equities.
The modeled Treasury-buying behavior of the foreign central banks has had a very good track record in anticipating the actual CB purchases based on TIC data.The so-called Masters of the Universe (MOTUs, the G-SIBs)) and Primary Dealers (PDS) understand this behavior very well and often front-run the central banks. The PDs buy low (high yield levels) and sell high (lower yield levels) to CBs. The rest of the MOTUs usually buy in concert with the G-SIBs and foreign central banks, and official institutions.
Falling yields, near term from now, may initially help a sort of melt up in equities. It is just central banks now which are gorging up on long term securities, as these buyers are more or less insensitive against temporary losses. It is when Institutional bond investors make the switch that equities start getting creamed.That switch will happen. S&P Earnings Yield spread over 10Yr yield will continue to shrink, and becomes less competitive vs bond yields until Q4 2021 (see chart above).
Finally, our Bond Yield-Equity Correlation Coefficient model shows that the negative covariance between equities and 10Yr yield has come to an end; the inflection point may have been seen.The correlation coefficient should henceforth go to positive (+1), as both the index and the bond yield falls together, until July at least. The 10Yr bond yield will probably fall at a faster rate than the DJIA -- bond prices will likely outperform.
Conclusion: we have like see the top of the bond yield rally, and may see the long bond yield falling until sometime in Q4 2020.
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