MOVE-ing the Dial

Currently, there is not only a growing groundswell of opinion that central banks are likely to continue their present policy of ‘emergency’ monetary infusions à outrance, but also a heightened awareness that many of them are now pleading for the state to abandon the very last vestiges of restraint in their resort to debt financing.

“Just spend”, they implore, “and we’ll make sure that all the paper you issue will find at least one willing buyer – namely, us!”

Long conditioned to view monetary policy alone as impotent in this regard by their interpretation of Japan’s experience these past three decades – as well as by the twelve years which have passed ‘fruitlessly’ trying to quicken the rate of increase in prices elsewhere in the West, post-Lehman – the consensus does seem much more willing to accept that debt monetization – whether accorded the trendy moniker of ‘MMT’ or not – will fulfil its perpetrators’ aims of lowering people’s purchasing power much more rapidly than has been the case of late.

Leaving aside the issue of whether such a ‘success’ would indeed be a blessing to those upon whom it is showered, much is being made of the back up in nominal bond yields underway since the start of August – a move which has both added some 35bps to the long bond and steepened the curve by almost as much against a largely anchored short-end.

The fact that yields on the inflation-indexed TIPs have hit new lows over the summer has also occasioned two, not entirely compatible frissons of excitement to run up and down the spines of market watchers.

On the one hand, we have the Ivory Tower mob who insist that this fall in observed ‘real’ market yields is a sign that a mystical construct called “R-starred” – the so-called ‘neutral’ (sometimes, ‘natural’) rate of interest needed to usher in the dull tranquillity of economic ‘equilibrium’ – has declined.

These pointy-heads generally never stop to wonder whether the drop might just be an artefact of the convoluted goings-on on Wall Street but instead assume that these allegedly ‘rational markets’ could not possibly err in their assessment. The shift is, they therefore contend, representative of a much more profound change in economic conditions and in the degree of implicit distinction people are making between goods today and goods tomorrow (in their ‘time preference’).

Hence, the PhD crowd believes that TIPS yields tell it something meaningful about whether people are suffering from a shortage or surplus of investible funds as well as about the prospects, gloomy or otherwise, their owners see for the returns to be had from any investments they do make by means of them.

For the Professoriate, then, a low R* implies that just about ANY use of borrowed monies – even ones involving the notoriously inefficient and often corrupted business of government spending on ‘infrastructure’ – can improve public welfare while, for mainstream commentators, the low rate itself means that people are committing that most heinous of economic crimes – SAVING!

Either way, the argument runs, the state needs to suck up more of those supposedly excess funds, pick up that ready supply of ‘shovels’ about which we hear so much, and get to work staving off yet another threatened Great Depression (humanity never yet having quite managed to shake off the prevailing myths of what actually did go wrong during the real one, back in the 1930s).

Red Queens and Mad Hatters

In this particular instance, though, the low rates associated with TIPS are, as we have seen, being matched with a rise in the yields being quoted on their plain-vanilla counterparts. The difference between the two is effectively a measure of the degree of the average loss of real value of the coupon and principal payments of the latter to be expected over the lifetime of the security and hence is treated as a ‘break-even (average) inflation rate’, or ‘BEI’

A widening gap between the two yields is therefore associated with rising inflation expectations – traditionally seen as a BAD thing but, in the Carrollean Rabbit Hole into which we have long since tumbled headlong, now seen as a positive outcome!

Thus, since the third week of April when sentiment – and hence pricing – first began to stage a recovery from the initial COVID-19 lockdown shock, this gap – this ‘BEI’ – has expanded from a very meagre 70-75 bps, over a five-year horizon, to 160 bps, for a change of ~85-90 bps.

In the grand scheme of things, this may seem little enough but, by regaining the levels seen before the Spring collapse and – perhaps more importantly – by having forced a rethink in the face of a rising trajectory on the charts, this could easily trigger a self-reinforcing round of action and reaction, of realisation and expectation.

Such a dynamic is frequent enough in any of the various financial markets but it is especially prone to take hold in fixed income since so many of the routine processes of hedging and so many of the regulatory requirements have option-like qualities which serve to increase feedbacks in both directions.

Technically known to bond market veterans as ‘negative convexity’, this is basically a matter of the bread always landing buttered-side down when it comes to bonds.

In all this there is more than a touch of irony, for the potentially destabilising rise in break-evens out to 2025 has been driven entirely by a decline in the far less liquid TIPS yields with almost no contribution being made by the broadly unchanged ones quoted for the corresponding, medium-term straight notes

The Finger on the Scales

Why have TIPS yields moved so far, you ask?

Principally, because a rather large, price-insensitive, bottomless-pocketed buyer has been hoovering them up in the interim. Yes – you guessed it – the same Federal Reserve which talks of the resulting pricing matrix as if it were the spontaneous expression of the combined actions of the general public is, in reality, the one driving the changes.

Back in mid-March, when the Fed again started to shore up the collapsing financial superstructure, it owned $133 billion TIPS out of a total of $1,507 billion in issue (an 8.8% uptake). At the end of last month, that holding had swollen to $289 billion. With the total stock unchanged, its proportion had therefore rocketed to an unprecedented 19.1%.

Put another way, the ‘free float’ of such bonds available to all other buyers had declined by some 11.2% at a time when there was a rush for what are considered as ‘safe assets’ in general. Furthermore, as the Fed’s influence on pricing grew, yields on these securities fell, even though they were rising on all others as commodity prices and general activity recovered somewhat from the slump and as the demand for some measure of inflation protection consequently strengthened. The inevitable rise in the break-evens therefore not only validated the decision of the early riders of the Fed’s coat-tails but began to draw eager predators to sniff at the spreading scent of blood in the water.

So much for all that theorising about R-starred, I hear you say!

As for straight bonds, the Fed’s actions were not without import, either, though here it was a question of dampening other, more adverse influences rather than of overcoming them entirely.

While the overall count of notes and bonds in issue has risen $935 billion in the past 29 weeks, the Fed has gobbled up $1,747 bln of them, reducing the float by 7.8%. And this came as, simultaneously, government money market funds were accumulating $845 billion in new assets and large domestic banks were adding ~$190 billion to their stockpiles, in addition.

That this has helped prevent a much more marked rise in yields becomes apparent when we note that, based on their reported futures positions, one fairly important group of buyers has suffered a sizeable slackening of its appetite for Treasuries: viz., those making up the CFTC’s category of ‘Asset Managers’.

Since mid-March, these worthies have reduced net longs in Ultra-Bonds by 40%, in Tens by three-quarters, in Fives by a half, in Twos by 40%, and have reversed from long to the biggest short in 32 months in Ultra-10s. Only the traditional bond contract has retained their interest, with exposures there rising by 40% to reach a new record high.

In the past six months or so, then, on an overall, risk-weighted basis, Asset Manager exposure has dropped from just under $5.2 trillion of one-year equivalent risk (!) to $3 trillion – still a very sizeable wager, but also the lowest since well before the Risk-Off slump in the last quarter of 2018; an event which saw their penchant for fixed income turn to an outright mania amid that autumn’s equity rout.

Let’s a-MOVE it and a-Groove it

As for the seller of all this debt, it is by now common knowledge that, in the US as elsewhere, government deficits are ballooning. The last seven months of the fiscal year, since the virus first made itself felt, saw Federal revenues decline 6% in comparison to the same period in 2019, while spending soared 74%, and the deficit mushroomed by a factor of 5.7 as a result to reach a stupendous $2.5 trillion.

Each and every month since COVID hit, the gap has thus equalled the level it attained during the entire YEAR before the Lehman bankruptcy ushered in the GFC and threw all of our finances off course – arguably for ever.

Since we well know the Fed and its peers will not act with anything other than greatest reluctance to tighten policy if these inflationary presentiments do come good, it may be premature to play for the magnitude of rise in yields that evolution might otherwise seem to justify, especially not at the front end where central banks can naturally exercise much tighter control.

The bet, therefore, would be on further curve steepening – with the added kicker that what is already a very divisive and mean-spirited election battle, being waged between two parties vying to have the power to spend even MORE trillions into existence with the active collusion of the central bank, could end with either of the losers violently contesting the result and so dramatically shaking confidence in the markets.

Though volatility has perked up in the last few sessions, a MOVE index reading still only in the high-50s means it has gone from being unprecedently cheap to plain, old, run-of-the-mill inexpensive (~1.3 sigmas below the long-term mean).

Given the tendency for periods of suppressed vol to end in violent overshoots in the opposite direction – and also given the fact that a steeper curve inherently tends to make the built-in rate path more uncertain and hence to raise volatility – with a little imagination, one might still avail oneself of a cost-effective way to play for a continued rise in the 30-year yield.

A breakout on the shorter-term chart, together with hints of a series of cyclically-spaced lows on the longer, means one could position for a climb from today’s 1.55% to 1.70%, 1.90%, and perhaps even 2.15%, with stops (or bond calls) at 1.50% for the cautious and perhaps down at 1.40% for those with longer horizons or those who can otherwise envisage greater upside possibilities.

The closer we get to November, the more anxieties will mount. So, if the reasoning laid out here appeals to you – and if its suits your risk profile to do so – sooner would be better than later to act upon it.