Trouble in Yellen-Land

Bond markets and the Fed aren’t making sense.

The Fed (“Yellen”) rose the Federal Funds Rate (FFR) last Wednesday, June 12th to a range of 1.00% to 1.25%.

The Fed has two mandates: (1) to keep prices stable (i.e. keep inflation around 2%) and (2) to minimize unemployment. In other words, stabilize the economy by cooling it off when growth gets too fast and heating the economy up when growth slows.

The mechanisms to do this are two fold. The Fed can raise the “Federal Funds Rate” (FFR), making short term credit less available. The FFR is the lowest rate at which a financial institution can borrow. If you raise the lowest rate available in US markets, everything else should follow. Right?

Wrong. The FFR is a very short term instrument. Changes in the FFR only change short term interest rates. (See: Term Structure of Interest Rates). This brings us to our second weapon in the Fed’s arsenal: the Balance Sheet. The Fed can buy and sell securitized mortgages and government debt. They can hold assets on their balance sheet to synthetically alter the supply of debt at longer tenors.

Quantitative Easing (QE) by the Fed flooded markets with cash by purchasing bonds in the open market in order to promote lending (i.e. liquidity). The Fed’s balance sheet exploded… I mean EXPLODED. Check this post for relativity. In the most recent Fed statement, the Committee agreed it would soon be time to bring the balance sheet back to “normal”. This means they will no longer buy new treasuries or redeem matured securities.

Once balance sheet normalization begins, there will be less demand for Treasuries and yields should rise, ceteris paribus. Right?

However, longer term treasury yields have fallen while short term rates rose. This results in a flatter yield curve. Growth in the US and the world remains tepid; and inflation in the US remains under the 2% target rate, but the Fed sees fit to continue tightening monetary policy.

So what gives Janet? 

This morning, Lisa Shalett, Head of Wealth Management Investment Resources at Morgan Stanley, wrote: “… we believe the Fed has embraced a new narrative that extends beyond its mandate of full employment and 2% target inflation.”

The Fed isn’t raising rates because our economy is heating up; they’re trying to combat the next recession proactively. They’re ‘normalizing’ the FFR and the balance sheet back to levels where they can reasonably combat the next recession.

OK, but why the flatter yield curve?

A colleague of mine introduced the idea of relative interest rates as an additive theory. The risk/reward profile of US debt is one of the best in the world. For example, the 10-year government debt yield in Singapore is comparable to the same rate in the US. Would you rather have Singaporean dollars or US dollars given current market conditions? That being said, we have seen a sell off in the US dollar since the beginning of the year. Take a look at what has happened to the US dollar since President Trump took office:

USDsinceTRUMP

The dollar has rallied and subsequently sold off since the election. In my colleague’s argument, the dollar should rise. If there is a high demand for Treasury bonds, we will see a rise in demand for dollars. You can’t buy US government debt with foreign currency; you have to convert it to US dollars first. More buying of USD pushes up the price.

The recent bond market rally on the long end of the yield curve has pushed rates lower. This could be from more demand as per my colleague’s point; or the bond market is calling bullsh*t on the Fed’s optimistic outlook for the economy because a movement from stocks into bonds signifies a move to safety. When the 10- to 2-year spread tightens, it signifies lower growth expectations in the future.

tenminustwosinceTRUMP

When Trump was elected, stock markets rallied. The so called “reflation trade” became all the buzz and a “risk-on” mentality became popular. Check out the pop in the 10 to 2 on November 8-10th. This was a spark of optimism that the US economy might see some fiscal stimulus. Since, the bond market has postulated that the current administration might not be able to meet goals in respect to healthcare and infrastructure stimulus, thus spreads have narrowed and expectations tempered.

To review:

The Fed says we’re growing at a healthy clip, with inflation rising. Their reflation narrative is weak, and the bond market isn’t buying it.The Fed is trying to stockpile ammo before the next recession.

What I’m watching:

An inverted (i.e. negative) 10- to 2-year spread has preceded EVERY recession in recent history. Check it out:

10two

Keep an eye on the 10 to 2.

What I’m Reading:

Thanks for reading,

– Tommander-in-Chief

 

Disclaimer: there are SO MANY moving parts in finance. It’s impossible to point to any one factor because it’s always a combination of several or many factors that affects markets.

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