Weird Occurrings In The Bond Market… Even By Bond Market Standards
It is often difficult to distill the question “what happened in the bond market today?” to a single answer. The domestic bond market broadly encompasses high yield, investment grade and treasuries. Those markets do not always move in the same direction (especially high yield and treasuries on risk-off or risk-on days). Even the treasury market is often better explained by some combination of bull/bear and flatten/steeper than a single reference point. But for the sake of simplicity we often just boil it down to what happened to the 10-year bond. The 10-year treasury is the most followed reference point for the bond market. Most of the time, that does provide an adequate snapshot of what is happening in the bond market. But something different is going on now.
Conventional wisdom would allow the following headline to be correct:
Bond market expects Fed to hike, so yields rise.
The corollary is also usually true
Bond market reduces expectations of a Fed hike so yields fall.
Yet, something has changed in the past two weeks. Those statements are now patently false!
Daily Change in Treasury Yields
For most of September and early October, the bond market did its usual dance. The 2-year and 30-year yields moved in the same direction on most days, with the 30-year having larger moves.
But since October the 8th, the 2-year and 30-year have moved in opposite directions almost every single trading day (it has been exhibiting a similar pattern overnight again).
I think what the market is now telling us:
If the Fed blinks (due to inflation) and hikes, they will slow growth. That logic would explain why when the market starts to price in a more hawkish Fed the long end of the yield curve rallies, rather than selling off.
A dovish Fed is dangerous for longer maturity bond holders. When the market starts to price in the reality that the Fed is unlikely to hike, the front-end sees yields go lower, while the back-end has yields move higher as investors realize that growth and inflation are possible, and the Fed won’t protect their real yields.
So, for the moment, explaining the move in the bond market is much more difficult than normal, because a hawkish Fed does NOT translate to higher yields at the long end, which is counterintuitive at one level, but perfectly logical at another.
Sticking to the Script
Back in August, we laid out the Fed’s script in “Inflation – Yes, Hikes – No, Taper – Maybe.”
Act 1: Say it is Transitory.
Act 2: Question how it is measured.
Act 3: Say it is Transitory.
Act 4: Say it is Transitory but talk about multi-year averages.
Act 5: Discuss the importance of multi-year averages and hammer home how good inflation is to all those who question why we want inflation.
Act 6: Either policy shift or find more excuses to run hot.
I believe we are in the intermission having watched Act 3 and preparing for Act 4 to begin.
The play has been complicated with openings for multiple new regional presidents and some questions about whether Powell will remain in charge. Having said that, too many remaining members committed to the script that it seems unlikely to change. Furthermore, as I believe we have seen time and again, it is easy to talk hawkish until you are the one in charge of pulling the trigger, when the reality of potentially slowing the economy and incurring the wrath of the President and the entire population, is too much risk to bear (basically, as you get more senior at the Fed, the practicality of the job shifts you significantly to the dovish side).
Much of this was discussed on Bloomberg TV on Monday morning (link). Normally I’d highlight the time where Academy was on, but somehow, we made it through the entire hour long show without getting the hook.
I do not believe the Fed will hike. Their goals of creating inflation are real. They spent so much time saying transitory, it will be difficult to hike when there is always a risk of a coming slowdown. Also, their work on the jobs front, especially for minority employment is far from over.
No hike, but steeper curves with longer maturity yields creeping higher (caveated by a real risk of a serious “risk-off” mood that would be a huge bid to treasuries, which could be particularly violent since so many now seem to be underweight longer dated treasuries).
Equity investors seem to have been focused more on hike/no hike talk and not enough on where longer dated bond yields are headed, which is likely to enter their consciousness in the coming days!
Wed, 10/20/2021 – 10:45