Following Janet Yellen’s strange speech from Friday, titled “The Elusive ‘Great’ Recovery” in which a seemingly perturbed Yellen not only admitted that the Fed may have hit peak confusion and that 7 years after unleashing a global, multi-trillion asset reflation experiment, it has not only failed to reflate non-market assets (at least both bonds and stocks are near all time highs on central bank buying), but in which the Fed chair also admitted the Fed is not even sure it understands the phenomenon of inflation any more, and in which Yellen’s reference to stoking a “high-pressure economy” and the lack of a mention of raising interest rates (coupled with her suggestion that the Fed “may want to aim at being more accommodative” during recoveries) was initially seen as a dovish sign, the just as confused market first rose, then fell after it reintrepreted her comments not so much as dovish, but as refering “financial stability”, something that Eric Rosengren explained earlier on Friday refers to steepening the yield curve, which in effect is a tapering of long-end purchases, or – as we first dubbed it when previewing the BOJ’s similar operation – a reverse Operation Twist.
The result was a prompt jump in 10Y and 30Y TSY yields to session highs on Friday after Yellen’s speech discussing “plausible ways” to reverse adverse supply-side effects by temporarily running a “high-pressure economy”, but more importantly the 5s30s steepened. Indeed, the selloff in long end saw 30Y yields rise by more than 7bp, topping 2.55% for 1st time since June 23 Brexit vote, the 10Y yield was higher by 5bp at 1.791%, above closing levels since June 2, while the short end barely budged.
But the steepening mood started not with Yellen but with Eric Rosengren, the president of the Boston Fed President, who dissented from the FOMC’s decision to hold rates steady at its September meeting, and who said is perplexed by historically low 10-year Treasury yields, which “haven’t rebounded as in other recoveries, with investors willing to accept a vanishingly small premium over their inflation expectations to hold them.”
Perhaps the reason for that is that despite the endless rhetoric, there hasn’t actually been a, you know, “recovery.”
As Bloomberg’s Daniel Kruger observed, Rosengren cited the Fed’s extensive holdings of 10-year Treasuries as a reason, but speculated that there’s a more likely and enduring cause: safety, in the wake of the financial crisis, is more expensive than it used to be. “It’s a global phenomenon. In 2006 a 10-year Treasury buyer received 2.3 percentage points more in interest than the market’s 10-year inflation forecast. That’s fallen to 0.2 percentage points this year. Spreads have narrowed in Japan and Germany, as well. Buyers of 10-year JGBs now get 0.4 percentage point less, and in Germany it’s an 0.8 percentage point less.”
So, not surprisingly, just like the BOJ before it, Rosengren suggested to use the Fed’s balance sheet to steepen the yield curve. The gap between five- and 30-year debt has widened 0.24 percentage point from the 20-month low of 1.03 percentage points in August. And with about one-fourth of the Fed’s $2.46 trillion in Treasuries matures in 2027 or later, selling a portion would certainly widens the curve even more. However, it will most certainly backfire should investors sell risk assets in order to fund purchases of long-term Treasuries at suddenly higher yields, which as we explained just over a month ago, is the dreaded VaR shock scenario where a rapid selloff in bonds promptly migrates to other risk assets courtesy of risk-parity deleveraging, which in turn forces a scramble for “safety”, i.e., the very same long-maturity securities, whose selloff prompted the panic in the first place.
Indeed, as Kruger points out, removing stimulus from the long-end of the bond market isn’t going to boost risk appetite in broader financial markets or stimulate growth. In other words, it will lead to more selling, something which US equity futures appear to be doing right this very moment.
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The Fed is not the only one suddenly expecting a notably steeper yield curve. Over the weekend, Deutsche Bank’s Dominic Konstam who until recently expected the 10Y to drop as low as 1.25%, has also changed his mind and now expects the long end to rise due to the market’s expectations of further steepening.
But it won’t all be song and games, because as Dalio and Goldman have both warned, should rates move too high, too fast, MTM losses will become so great that the move itself will provoke a scramble right back into fixed income, and other deflationary, assets.
This is what Konstam said in his Credit Weekly publication:
If we are right and yields continue to rise with the curve steeper, there will inevitably be concern for risk assets and perhaps for the economic “recovery”. For this reason we think investors should view the moves as more tactical rather than structural and, importantly, consistent with easier policy at the front end. In the extreme the BoJ and ECB can ease still further to underwrite the steeper yield curve while the Fed can delay hikes for longer. While many investors have been lulled into a sense of low long rates are desirable, we continue to think that the central banks are shifting gears whereby steeper yields curves per se are more desirable for helping to stabilize bank profits and higher long yields per se for the entitlement industry as well as to soften the hunt for yield that may be driving excessively low risk premia in risk assets. The BoJ target for zero 10s is clearly in this framework – although as we argued two weeks ago the logic must be a dramatic decline in short rates to support 1s5s JGB curve steepening AND 5s10s JGB curve flattening so that 5y5y can fall or at least be stable relative to the US especially, despite sticky 10 year JGB yields. In turn, this will allow for a weaker yen. A weaker yen is critical to raise inflation expectations – it is about the only thing that matters for Japanese inflation. As of now note there has been a decent steepening in 1s5s (5 bps over 2 weeks vs. recent low of just 7 bps) while 5s10s has been stable to slightly flatter although overall 5y5y is slightly higher.
Rosengren’s statement that…”[I]f one were concerned about the historically low 10-year Treasury and commercial real estate capitalization rates, perhaps because of potential financial stability concerns, the balance sheet composition could be adjusted to steepen the yield curve” After the Great recession. A Not-So-Great Recovery FRB Boston, October 14, 2016, we think is an important new augmented angle from the Fed that fits well with our thesis. Below we look at options that the Fed might take in the event that it also wanted to steepen the yield curve.
As an illustration of the sorts of financial stability concerns we have been highlighting the richness of the SPX in relation to real yields and breakevens and specifically how this richness has been achieved via specific sectors that have performed increasingly well even as breakeven yields have fallen – the coefficients have effectively flipped since 2013 for sectors like healthcare, utilities, staples. This shows up as a compression of earnings yields to (falling) nominal yields via lower real yields and stable to lower breakevens. Restoring risk premia in the bond market therefore will at least forestall a further richening in risk assets but may also allow for some reversal. To the extent that breakevens recover with real yields still relatively low should at least though limit the risk asset correction – a pause that refreshes rather than a tantrum. Again the idea is that this is tactical not structural. There is an important distinction to make versus late last year when the fed was not just hiking but threatening to hike every quarter so real yields themselves had a full on tantrum as the dollar soared. This is exactly what needs to be avoided and we expect it to be avoided in the context of the current ongoing policy re-jig.
Twist Reversal?
Treasury curve steepened on Rosengren’s comments about adjusting Fed’s balance sheet to steepen the yield curve on financial stability concerns. The change in Fed’s balance sheet composition could steepen the yield curve similar to how Twist flattened the curve in 2011 and 2012. Fed portfolio extension during Twist was worth about 45-50bp in 5s-30s based on our model.
We fit 5s-30s curve to Fed funds to 2s and Fed portfolio average maturity from November 2010 to December 2012 to capture Twist effect. The original intension was to extend our ten-year bootstrap fair value model, which uses Fed funds to 2s and Fed funds target as input variables, to curve slope by adding the Fed portfolio maturity variable. As Fed funds target was unchanged during that period, that variable becomes irrelevant. Note that the Fed portfolio average maturity dominates in the regression with a -4.4 t-stats and a six-month lag. Twist contributed 50bp to the 5s-30s flattening during that period.
The coefficient on the Fed portfolio average maturity is about -0.014 per month. A one-year change Fed portfolio average maturity is worth about 17bp in 5s-30s.
To change the portfolio composition, the Fed can stop reinvestments of maturity coupon debt at 10- and 30-year auctions. Treasury then needs to borrow more from the market in the long end, steepening the curve. Alternatively, the Fed can stop reinvestments of maturity coupon debt at all auctions and use the proceeds to buy short dated coupon debt in open market operations while keeping the balance sheet stable.
One final warning: it was Rosengren’s comments, together with the hint that the BOJ would proceed will full blown curve steepening, in the week of September 5 that spooked markets which not only ultimately led to a dramatic steepening in the JGB curve, but also to the sharpest drop in the S&P since Brexit. Now, one month later, we have another set of even more vocal Rosengren comments and this time it is not the BOJ but the Fed which is suggesting the next big monetary move will be not more easing but implicit tightening via Reverse Twist. Meanwhile Libor is soaring and pressuring everyone who has floating exposure, while the rising long end is about to put an end to any housing “recovery.” As such, keep a close eye on risk assets not just overnight but in the next few days, as a “deja vu all over again” moment is increasingly likely, especially if the Ray Dalio’s of the world decide they would rather sit this one out…
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