The Fed is not in control of the yield curve. No one is.
The three things I would tell my clients this morning:
US Debt is rising and the Fed is not buying any more.
Additionally, geopolitics threaten to destabilise inflation again.
This leads to one conclusion: The long end of the curve now has a life of its own. Investors thinking that the Fed is in control and can bring yields back down whenever it wants, need to think twice.
It sounds like a meme, but it actually happened. After a heated argument with a dear family member last week, I decided to do what nice boys do and went to buy flowers, hoping, in vain of course, that I could resolve matters swiftly with £20 worth of generic orchids. Unsurprisingly I didn’t, and another loved one joined the dangerously elongating queue of people annoyed at me these days. As I approached the register, my florist asked me whether he should be buying the US 10y Treasury or whether he should go short duration.
My jaw dropped!
I have spent 20 years in financial markets. Bonds are generally a little-understood asset class, despite the fact that they are the biggest one and that debt makes the world go round. They mostly depend on the macroeconomic environment, their risk is non-linear, duration is an obscure concept and, besides, everyone prefers talking about tech stocks. I have met Chief Investment Officers who needed someone to explain the difference between maturity and duration. And here I am, talking to a kind and unassuming little 70-year-old man serving customers in a small Athens neighbourhood, about the US yield curve. Again, not a story to impress, but an actual event. And the lesson from that is, more often than not, that one should be wary of an asset class that has caught the attention of retail so much.
With the S&P treading water in the past few months, all eyes are of course on bonds. Until the Middel East conflict erupted, yields, especially at the long end, were picking up. The US 10y is reaching the 5% mark. It was not long ago when we all agreed that we would begin looking at it when it crossed the 2.5% mark. A generation that hasn’t seen a yield is now enticed by it. Sage investors will of course go for the yield, which means they will aim for the maturity matching their liabilities. They already acknowledge that bonds are very volatile right now, and are well-warned by JP Morgan boss Jaime Dimon that yields could hit 7%.
However, at the back of most investor’s heads, is the assertion that the Fed is still in control of the yield curve. After all, with Quantitative Tightening it can control the demand of shorter term issuance. And if it decided to buy long bonds again, as Gavekal’s Louis Gave suggests might eventually happen, in order to monetise the huge debt, it could control both ends. So when purchasing a bond, many think that the yields will stop rising when the Fed wants them to.
I believe that, at this point, this self-assurance is false. Last week is telling of things that may come for a generation that re-discovered bond yields. The new war in Israel temporarily brought yields down, only for them to rebound again. And, more important, Fed officials acknowledged that higher bond yields reduce the need for the Fed to raise short-term rates, which means that the Fed has officially paused.
A few weeks ago, the Fed was warning of further hikes. Now, that yields have moved more swiftly, the US central bank changed its rhetoric. The moral of the story is that when inflation is not under control, the central bank is not in control of yields.
The Fed’s lack of control is not difficult to substantiate.
Last week’s inflation number in the US was once again higher for the third straight month. And even though the super-core inflation (ex food, gas, housing) is stable, we could be faced with a third inflation wave that has yet to translate into renewed demand-side pressures.
At the long end, especially, where the Fed is absent, the US government is present with an increasing supply of debt, possibly more than the market can digest. Every month, US government institutions are price-insensitive sellers of debt worth $US 220bn. $21tn of Federal debt needs financing from someone else other than the Fed, which is contracting its own balance sheet at the pace of $60bn per month. A recession could cause an additional need for $1.5tn of debt per annum. Can the market digest all this debt issuance?
Presently, there are two major wars, in Eastern Europe and Israel, that affect energy and food prices. The geopolitical backdrop is as unstable as the 1970s, if not more so. Wars are inherently inflationary.
So investors should bear this in mind. Currently, the yield curve is disinverting as the long end is becoming unhinged. For long term yields to come under control again, especially with such high issuance and the absence of the central bank buying, inflation needs to come under control. We are not there yet. When geopolitics is unstable, inflation tends to come in waves.