I assume many of my British readers will be nursing hangovers this morning, after England made it through to the Euro 2020 final. After thinking about an opaque bond market all day on Wednesday, I needed a drink too. If you know the secret the market is concealing from me, email it along: [email protected]
Plenty of explanations for falling yields, none of them much good
I’ve been away for a week or so. The important news since I left is this:
Treasury yields have really crashed at the long end, and the yield curve has flattened significantly. There has been a matching move in equity markets: the growth/technology stocks have extended their run against value/cyclical stocks.
This looks like a pattern. This is what you would expect to see if something has happened to damp expectations for inflation, economic growth or both. But there has been no whopping big chunk of news — or even a tidy pattern of little newslets — to neatly explain why the downward trend in yields and flattening curve that started in the middle of May should suddenly accelerate. Let’s see if we can tease out a clear signal.
To start, the move in yields (both in the past few months and in the last week) can be broken down into two roughly equal contributors: falling inflation expectations and falling real interest rates (as revealed in the yields on inflation-protected securities).
The drop-off in inflation expectations is hard to justify. Yes, several key commodities have cooled off. Lumber has all but normalised and oil has backed off from its Opec-related tizzy (the cartel seems unable to agree to a plan, and the market has reached the conclusion that means members will end up pumping out more crude). That aside, though, the inflation data keeps coming in hot. Below are Citigroup’s inflation surprise indices for emerging economies, advanced economies, China and the US. All are at peaks; the US and the advanced economies are both at long-term highs:
Something else the yield crash is not: a signal of investors shifting to a “risk-off” stance. Stocks, and not just the tech-heavy Nasdaq, are up against long-term highs. If that’s not enough, the Investors Intelligence bull/bear ratio is at a two-year high. Finally, the yields on the junkiest junk bonds have never been lower, and just keep falling. Data from the Federal Reserve:
Risk appetites are razor sharp.
Investors might be keen on risk because they think there will not be enough growth to justify Fed tightening. This would explain yields falling, the curve flattening and stocks flying high, given the (possibly mindless) mantra that low rates justify high equity valuations. But there is not much recent data to justify growth expectations falling, either. The June manufacturing and services industry Institute for Supply Management surveys were a little softer than in May, but activity and orders remain high. The pressure seems to be in supply chains, including the labour supply chain. But those problems should work themselves out before too long.
A more likely, if speculative, story on growth is that investors are simply waking up the fact that growth is peaking now. Deceleration, as I have written before, is not as fun as acceleration, however high the absolute level of growth may be. It may also be dawning on investors, as they read about the rise of the Delta variant in Europe, that the road to herd immunity may not run straight. But neither the fact that growth was always going to peak mid-year, nor the news about the virus, can have really snuck up on anyone. It should have been more or less priced in.
If bond yields are falling and the curve flattening, and neither lower inflation nor lower growth is a particularly compelling explanation, two possibilities remain. The moves could be down to “technical” factors — supply and demand changes that reflect investors’ positioning and market mechanics rather than fundamentals. Or they could reflect the expectation that the Fed is going to screw things up. Let us take each in turn.
Pundits have offered up lots of technical explanations for the directions of the market in recent days. I have already written about the procyclical hedging by mortgage investors. Another currently popular technical justification is pension funds scrambling to reposition themselves for the possibility that yields will fall still further, or to take profits after a great run in risk assets. Then there is the ever-popular seasonal lack of liquidity as summer holidays start.
But it’s hard to know what to do with these and other technical explanations, though. Pundits who offer them do not tend to offer them as trade ideas, for example as arguments that bonds are too expensive and will fall. Instead, they offer them as reasons to simply ignore the market shifts in question and proceed, tactically and strategically, as before.
And so we move on to the Fed. I have argued that the central bank has been quite clear about its plans, but plenty of people disagree. Anwiti Bahuguna, who runs multi-asset strategies at Columbia Threadneedle, argued to me that while neither the inflation nor growth outlooks have much changed, a lack of clarity from the Fed has the market pricing in a policy error. Traders simply don’t know what to make of the fact that the Federal Open Market Committee’s growth and inflation expectations hardly shifted, but their rate expectations, as expressed in the dot plot, clearly did. “The Fed needs to explain, if they are not going to be reactive [to short-term inflation data] why are the dots moving?”
Gregory Peters, a fund manager at PGIM fixed income, agrees, pointing to the fact that much of the move down in real rates has come since the Fed’s meeting last month, and that investors have shifted their expectations for rate increases going forward.
Why, though, has it taken several weeks to price in the Fed’s internal contradictions? The puzzle remains. Not much appears to have changed in the world, but markets continue to shift.
One good read
Michael Pettis, a finance professor who has been mentioned here before, wrote an interesting Twitter thread about the dilemmas faced by Chinese officials as they seek to solve their country’s pension problem by raising the retirement age. He lays out the underlying economic imbalances nicely in this essay from a few years ago.
Author: Robert Armstrong
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