TL;DR

Often when doing research, I come across market dislocations and oddities and late last week I noticed an extreme spike in yield for 1-month treasuries, to nearly 6%. This was not a garden variety yield curve inversion. For sure, the market has finally started to listen to Powell’s rate hikes (now at 5% to 5.25%) and with stubbornly high CPI, PCE and PPI; and eight-decade low unemployment, the inversion that started months ago is still in play as Powell keeps rates high.

But the 1-month spike to nearly 6% indicates much more than inversion. And the ‘much more’ is probably the heightened short-term risk of sovereign default with no agreement yet to lift the $31.4 trillion debt ceiling; plus, a liquidity crunch from recent bank collapses, and heightened geopolitical risk. It means the world is watching the U.S. and the reserve currency, and all eyes will be on debt ceiling squabbles in the U.S. tonight.

While in isolation the 1-month might look like an attractive entry point if you’ve just returned from a desert island, it’s focussing the world on the U.S debt ceiling and banking system instability, and it may be a yield trap with a sting in the tail if inflation reoffends and Powell continues to go hard. Some detail below.

Yield Curve inversion

A yield curve plots bond yields over different maturities on the same day. When it inverts, i.e., when shorter yields rise higher than longer yields, it signals short term risk.

It means bonds are sold on the basis that the next buyer is bidding up the yield/bidding down the price, to compensate for higher risks in the short term rather than the long term.

A sustained inversion, particularly when the 2-year inverts over the 10-year, has in the U.S. been an accurate predictor of upcoming recessions.

This recession warning has been sounding for many months - but still, unemployment is at eight-decade lows, and no sign of a recession! Even the PMI and PPI have not toally collapsed as predicted by many economic commentators.

The current curve

Here is the yield curve as of 11 May 2023 (see red line which hasn’t changed much since I wrote this over the weekend) as well as three companion curves on different dates, namely:

1. 26 April (gold) a week before the 3 May FOMC meeting when the market was fading (ignoring) Powell’s warnings of higher rates for longer.

2. 3 May (green) when Powell announced the last 25 basis point hike which took us over 5%.

3. 4 May (blue) one day after the announcement - showing a 185bp increase in the 1-month yield since the week before the Powell’s announcement.

The spike

The 1-month Treasury yield has spiked (up) 190 basis points in a little over 2 weeks. That’s a big spike!

This extreme inversion over other maturities is unusual and signals something very different to the other short maturities which remain inverted over the 10-year. It’s not a garden variety inversion.

So, what the hell is happening with the 1-month, and why the massive spike?

I think there are three drops of poison in that spike that we can think about:

1. The U.S. government runs out of unallocated money in a couple of weeks. Until there is agreement to raise the debt ceiling above a disgustingly high $31.4 trillion (or reallocate other spending to the interest bill) the short-term risk of a U.S. default starts to get real. Naturally, investors are worried about the creditworthiness of the U.S. and are demanding higher yield/lower price to own 1-month paper. Some would also be selling 1-month paper to avoid potential losses.

2. Geo-political sentiment is getting worse. Russia/Ukraine is unresolved. OPEC’s production cuts are playing havoc with oil price and dollar strength. China has stagnated. China/Taiwan is becoming clear and present again given China is being starved of U.S. GPUs and memory chips. It’s unlikely that India will take over as the world’s steel mill or factory. Korea is flirting with dangerous weaponry. In response, more investors would be sitting in cash or going to ‘safer’ assets which in itself reinforces the perception of less-than-ideal creditworthiness, as per point 1.

3. There’s a massive demand for short-term funding/collateral because we’re basically in a liquidity crunch as a result of the SVB/Signature/Frist Republic/Credit Suisse collapses/failures. This, I believe, has caused investors to sell off what was once attractive short-term paper to rapidly raise cash as banks become more reluctant to lend. Cash can be used to weather the liquidity crunch and/or take advantage of opportunities that may arise as result of the fallout.

It feels like the spike in the tail is the market screaming that there are some major short-term issues at work, and rightly or wrongly, it’s now driving sentiment in equities, crypto and other risk asset classes.

But Biden, Yellen and Powell are pretty calm, right? And it’s probably because they know they can use big strong banks to acquire smaller weaker banks and insure/print us out of this problem. That’s code for ‘kick the can down the road’ by re-engaging QE Infinity, if needed.

What now?

The sentiment in bonds is screaming risk at the extreme left-tail of the yield curve. The 1-month spike appears to be something more than just a garden variety inversion.

It’s screaming potential default and short-term banking system instability, and this was not helped by JP Morgan’s announcement that it has set up a banking crisis war room. Probably a trigger in the same way that Elon Musk can move markets with a solitary tweet.

However, we only need one or two of the following to happen for things to reverse sentiment. If the debt ceiling is lifted (which it must), OPEC relents, China stimulates (although not sure why Xi would do that), Russia surrenders, more banks don’t go down, yada, yada, yada, and then we perhaps see the sting neutralised and short rates come down again (and a few glum faces at JP Morgan). That scenario would translate to higher rates for longer with the BTFP and discount window running interference for Powell.

On the other hand, maybe a few more pesky/risky/entrepreneurial regionals go down (to the Fed’s relief), a major banking crisis ensues (to Jamie Dimon and his competitor’s relief) and big banks buy market share at cents in the dollar with a Treasury Put, and the Fed stimulates/buys Treasuries and MBSs and stops running off its balance sheet.

Under that scenario, short rates come down, the curve de-inverts and bond/equity prices go up.

So, if you’re a gambler, are you feeling lucky?

See you in the market.

Mike