Money never sleeps even if Fed does
Gordon Gekko, Wall Street, Money Never Sleeps.
End of the 40 year bond super cycle?
Generally, investors look for the best return they can find for the level of risk they are prepared to assume.
Since March 1981, the Fed has managed the federal funds rate all the way down to 0%-0.25%.
It’s interfered in treasury markets under exigent (emergency) rules.
In doing so, it has influenced down treasury yields using its now favourite weapon, quantitative easing (QE) - and lots of it.
Why? Ever since Alan Greenspan introduced modern QE, the U.S. Federal Reserve has relied on it to ‘print’ America out of all of its crises and problems.
And with yields having fallen from over 15% in 1981 to less than 0.5% just after COVID hit last year, the 40 year party’s just about over, unless rates go negative.
The casualties? Too much debt and impotent liquidity. A near total reliance on monetary policy, and a Fiscal machine that seized up (other than for welfare cheques) about 40 years ago.
QE opens the door to bond vigilantes.
End of the 40 year bond super cycle? Maybe. But money never sleeps and sooner or later, markets strike back.
What I mean is that since the emergence of the vaccines in November, Biden’s election sweep, and improving vaccination rates - bond yields have slowly started to rise.
As per the chart below, yields are now well above the 0.3% trough in August 2020.
How did this happen?
Well, it wasn’t for a lack of the Fed trying to keep rates low.
No, yields have risen to around 0.86% for the 5 year and 1.63% for the 10 year, because bond vigilantes have decided to sell bonds and buy more attractive assets, like equities.
And when bonds sell off, the price of a bond drops, but its yield to maturity rises because you can buy the same future income stream for a lower face value.
A bond vigilante comeback.
As seen in the previous chart, the short bond/long equities spurt peaked in April, after which yields fell slightly.
But more recently yields have started to rise again due to renewed market expectations of inflation overshooting the Fed’s 2% target, and injecting more positive animal spirits into energy & commodities, banks and overall, equities.
Below you can see the general move up in inflation expectations – now up to 2.6% as of last Friday.
It’s probably a little early to confirm this trend, but equities work on sentiment and the allure of higher corporate earnings which seem to be playing out nicely - despite U.S. majors under-promising Wall Street and then over-delivering into positive earnings surprises.
But the point is that vigilantes won’t come back into bonds in any meaningful way that can take weight off the Fed, until they see yields that are high enough/prices that are low enough, to tempt them to put the trade back on.
Clearly, this Fed didn’t read Sun Tzu.
Gekko told Bud Fox to read Sun Tzu’s, The Art of War, specifically: every battle is won before it’s fought.
I don’t think the Fed read that part.
On the one hand, the risk of a lack of liquidity or an inability for borrowers to service debt if rates go up too much (like in 1929) means that even if the Fed wanted to, any taper or rate hike would be minimal, and gradual.
On the other hand, the Fed doesn’t want to taper its $120 billion in monthly purchases. This is under a belief (or appearance) that inflation is transitory and ample liquidity is still required to jack up the economy until labour slack has been reduced.
It’s trapped, and hasn’t yet found a way to win this battle. That’s why some of its views and comments seem paradoxical.
If it had read Sun Tzu and/or learned the real lessons from 1929, it would have won the battle long ago with the beginnings of a slow but sure normalisation.
Vigilantes send their money never sleeps message while Biden plans Fiscal jailbreak.
Regardless of the reasons for the Fed’s non-action, bond vigilantes are sending a message to a seemingly sleepy Fed, that goes along the lines of:
“Thanks for 40 years of largesse and for the buyer of last resort backstop, it’s been a great trade. But if you really want us to participate meaningfully in the bond market right now, you need to offer a better yield (lower prices) or we will continue to pile into other assets and jack up their prices - lots of love, @GordonGekko”.
And maybe that’s why Secretary Yellen, VP Harris and President Biden are seeking to partially finance the twin deficits as well as the infrastructure and families packages (yet to pass Congress) with tax hikes.
And why not try it. Hell, the alternative is that the Fed remains the only buyer of treasuries, and its $7.8 trillion balance sheet doubles.
Hey Jay, this is your wake up call, pal. Go to work.
Gordo.
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Image attribution: Edward R. Pressman Productions, Ixtlan Productions, Dune Entertainment.