Over the last 35 years, the US 10 year yield, which many consider to be the global benchmark, has been in a clearly defined downtrend. When the yield has touched the top of this trend channel, it has often coincided with or been the catalyst for some of the major market events over this time period. It preceded the 1987 crash, the 1991 recession, the dot com bust of 2000, the market peak in 2007, and the bear market of Q4 2018. Today the US yield is still a long way from the top of this channel. But given the size of today's underlying debts, investors are concerned that tolerance levels to higher yields are now much lower. Where could that tipping point now be? That's The Big Conversation.
Rising yields are not themselves a sufficient factor to knock back equity markets or push economies into recession. If growth is strong, then higher yields are a natural consequence of that growth. But, if higher yields are combined with underlying excesses such as high levels of leverage, or an early rate tightening cycle, then this could tighten economic conditions and push risk assets over the edge. All the major recessions of the last 30 years have seen the Federal Reserve raising interest rates, so that rising yields have also been accompanied by a flattening and inversion of the yield curve – driven primarily by the increase in front end interest rates. Three of the last four recessions were accompanied by this yield curve dynamic. Before the COVID pandemic, the yield curve also marginally went into negative territory, but the final part of that inversion was created by a convergence of long end yields such as the 10 year down to the front end yields.
Although there had been some hawkish comments recently, it is extremely unlikely that the Fed are going to be increasing interest rates, or even tapering their QE program, during 2021. Therefore, the bear flattening and inversion that preceded previous recessions is unlikely to be revisited in the near future. If anything, based on the expected issuance of bonds as part of the fiscal support packages during the COVID crisis, QE will have to increase rather than decrease. Perhaps a better indication of today’s risks from higher yields is the experience of 2018. Prior to that period, global synchronized growth had started to pick up, with a couple of years of emerging market outperformance from 2016 to 2017. It felt like the global economy was on a much more robust footing. The Fed, who had halted their QE operations at the end of 2014, had started quantitative tightening, shrinking their balance sheet, with the pace picking up at the beginning of 2018. If investors were wondering where the tipping point was for US yields, they found out in in third quarter, when the 10 year yield surged from 2.8% to 3.2%. That marked the beginning of a 20% pull back on the S&P500, which was given extra impetus after the misstep of the Fed, who increased interest rates at the December meeting which led to an accelerated decline in the equity market, forcing the Fed to halt their tightening bias. A few months later they started cutting rates again and halted their balance sheet contraction. Low growth coupled with expectations of liquidity have been better for US asset price performance, than an environment of robust economic growth.
The issues that policy makers and investors face today, is that, even pre pandemic, the world was awash in debt, especially corporate and government debt. Excessive debts are not necessarily a negative if the ability to pay those debt remained manageable. The lowering of interest rates and the extension of maturities has seen many regions experience lower financing costs even as total levels of debt increased. But, during the pandemic, debt levels have expanded. Government fiscal packages have pushed many regions debt ratio well above 100% of GDP. US corporate debt to GDP was already at a record levels after years of debt financed stock buy backs. This has moved higher again during the pandemic. The drawing down of emergency credit lines has also seen M1 and M2 exploding higher, fueling the debate about future inflation, even though most of this activity has been a precautionary measure and may well be returned, rather than used.
US household debt to GDP has also surged during the 2020 crisis. It remains far below the peak levels of the housing and mortgage crisis, but this disguises a significant inequality in the ability to service those debts.None-the less, this sets us up for a tricky time period in which fiscal and monetary policy plus the hope of a swift vaccine solution has increased expectations for a “reflate and rotate” outlook for 2021, including higher yields. And it’s an overwhelming consensus at the moment. But could rising yields upset the shaky equilibrium? The Fed maybe on hold but other funding measures can and do detach themselves from the Fed’s interest rate anchor. We’ve seen the December 2023 Eurodollar futures contract sell off just over a week ago – implying higher funding costs. A key question is “what is the tolerance level of the market and the Fed to higher yields or dislocations in other funding markets”? The top of the long-term 10 year yield channel is 2% - now that feels to high considering that, if some of the northern hemisphere’s economies are going to experience a double dip recession, yields should be falling, not rising.
The consensus for where yields can go, according to Morgan Stanley strategists, is 1.1% to 1.3%. The most recent breakout in the US 10 year peaked around 1.2% - right in the middle of that range. Although there has been a bit of profit taking on the reflation trades since then, it hasn’t felt like yields have reached a game changing level yet. And who will blink first? Will the Fed signal their tolerance levels to the market, or will the market have to test the tolerance levels of the Fed by providing the sort of wobble in the S&P that creates a policy reaction. The Fed, who in the early phases of the pandemic were the most aggressive of the central banks, have since taken their foot off the accelerator allowing other central banks to overtake them. Policy makers tend to be reactive rather than proactive. It may need a market dislocation to accelerate the policy response. The widespread fear that higher yields could destabilize markets can, however, also work to the Fed’s advantage. Fed members have talked about Yield Curve Control but have generally dismissed the need for it. Because they’ve been talking about it, however, there is now an implicit threat of policy action.
Yield Curve Control is where the Fed would target a specific yield on a specific part of the yield curve. In the case of the Fed, most people assume that this would be a cap on yields, but yield curve control can also be initiated to stop yields falling, which was the case with the Bank of Japan in 2016. But once the idea has been floated, however, market participants will often be wary of the potential for action, even if it is an implicit threat rather than an explicit policy tool. Central bankers are in many ways confidence tricksters, hoping that their verbal intervention will prevent asset prices from reaching levels where they would need to actually initiate the policy. Currently, conditions are uncertain enough for market participants to be wary of pushing yields too far. The prevailing global conditions can also counterbalance a squeeze higher in yields. US yields have recently broken out above 1% for the first time since March 2020. But whilst US yields have been edging higher for over 6 months, other major bond markets have seen their yields moving sideways.
Yields on the German bund have been oscillating about 15 basis points either side of the -50 line for the last 7 months, whilst Japanese 10-Year yields have been in a 7 basis point range. If US yields are moving higher in isolation, then these yields will become increasingly attractive to foreign investors and this will be a self-correcting mechanism.Central banks have been trying to keep a lid on volatility and they have been doing a reasonably good job. The bond volatility index, called the MOVE index is currently close to the historical lows. Even if the Fed doesn’t need to vocalize a need for Yield Curve Control, the market knows that they have unlimited QE at their disposal, where the amounts and speed of bond buying could easily increase. The next FOMC meeting is on January 27th, though it seems highly unlikely at this stage that they will announce anything new because of the lack of activity in bonds.
Primarily, the Fed will be keen to avoid a repeat of the 2013 taper tantrum, where the market reacted aggressively to the announcement to reduce bond purchases. US 10 Year bond yields rose 140 basis points in 4 months. The US equity market shrugged this off, but the impact saw a pickup in out flows from emerging markets. It also marked the beginning of a series of events which saw other central banks try to pick up the slack that had been left by the Fed, which ultimately led to the dollar squeeze in the following year, a collapse in commodity prices and a recession in industrial profits.
Now the lesson that was therefore learnt in the middle of the last decade is that Central Banks don’t like sudden moves in asset prices and will try and prevent them. If yields grind higher, then markets can adjust, especially if the move is on the back of improved growth expectations. The Fed will therefore be focused on real yields - that is, nominal yields minus inflation expectations.For most of the last year, it has been inflation expectation that have been moving higher, in anticipation of loose fiscal and monetary policy. Nominal yields have largely moved sideways, such that real yields have drifted lower. Lower real yields are considered to be loose conditions because, in theory at least, it discourages savings in favour of spending and investment – though the reality is somewhat different. It should also be noted that inflation expectations have been pushed higher, in part, by the actions of the Fed, who have been relatively aggressive buyers in the inflation protected treasury market, or TIPS. They can continue to buy these securities, but it maybe that inflation expectations struggle to lead the move in nominal yields from here, putting the emphasis back on real yields.
The central bank will therefore focus its efforts on maintaining a low level of volatility in real yields, threatening intervention even if there is little intention to do any, whilst hoping that the differential in yields between the US and other international benchmarks can provide some support for bond prices and a cap on domestic yields. Portfolios that have heavy exposure to emerging markets could use the US bond market as a partial hedge, buying put protection on instruments like the TLT to hedge again the sort of higher rates that could undermine reflation assets. Last week we outlined the dollar as a hedge to a reversals in the reflation trade. Puts on US longer dated bonds would act as a hedge to the reflation trade becoming an inflation trade, but without growth – US 10 year yields beyond 1.5% could be very tricky indeed for this environment.
You would still need to be extremely nimble, because if US yields reach a level which destabilizes equity, then the reversal in bonds could also be extremely swift, as we saw in 2018, where yields fell 50 basis points in 2 months, and then continued to decline through the first half of 2019. The US Federal Reserve is engaged in both explicit and implicit manipulation of US yields. One of the other main determinants of asset price performance is the US dollar. Former Fed Chairman Janet Yellen, tipped to be the next Treasury Secretary, has stated that she doesn’t seek a weaker dollar and that the exchange rates should be determined by the market. Is this a significant statement? We’ll cover the US currency intervention in the next section.
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There was a lot of chatter during the Trump administration about a weaker dollar policy, though Treasury Secretary Steve Mnuchin has always argued that his comments at the World Economic Forum in Davos at the beginning of 2018 were taken out of context. In the last section, we discussed the ability of a central bank to verbally manipulate prices in the bond market. Currency markets, however, are often beyond the control of just the actions of the country that issues the currency. In fact, after Minuchin’s weaker dollar comments in 2018, the dollar actually rallied until just after the peak of pandemic panic last year. Direct currency intervention is now generally frowned upon and the ability of policy makers to unilaterally set the level of their currency is very limited. Some analysts have jumped on Yellen’s recent comments to say that she hasn’t re-iterated the ‘strong dollar’ verbal policy that was popular amongst a number of previous Treasury Secretaries. Even if she had, however, the markets would have only had a fleeting response. There are far larger forces at work. Therefore, Yellen’s comments are not particularly surprising. Direct currency intervention is relatively uncommon by major central banks. Prior to August 1995, the US did have frequent forays into the FX market, but since then, it has only occurred on three occasions, and those interventions were collaborations with other central banks.
In 1998, Dollar Yen was rising rapidly – the Yen was weakening and both Japan and the US intervened, pushing Dollar/Yen back down. The currency still made a new high, but momentum had started to reverse – eventually the Yen saw a staggering rally in the later part of that year as the collapse of the hedge fund Long Term Capital Management roiled global markets. On September 22nd 2000, the US, Europe and Japan all intervened to try and halt the decline in the euro which had reached its lowest level since being official launched in 1999. As with the Yen, the currency made one more low, before reversing and its never seen those levels since.
The third occasion in which the US direct intervened in the currency markets was in combination with other G7 countries to stop the Japanese Yen from rising too quickly after the devastating earthquake and tsunami of March 2011. Although the Yen still strengthened into the end of that year, much of the excess volatility had been removed from the market. For policy makers, orderly markets are often as important as the absolute level of a particular currency or asset. As we saw in the previous section, central bankers have been trying to cap the volatility in the bond market. Currency assets have also been relatively subdued.
Now on those three occasions when the US intervened in the currency market since 1996, it's because there was a crisis, there was the LTCM crisis of 1998, there was the euro at record lows in 2000 in the midst of the dotcom crisis, and then there was the Japanese earthquake and tsunami. And obviously the most significant intervention of the last 40 years, the Plaza Accord of the mid 1980s was also a concerted effort by a multitude of countries to stop the rise of the US dollar, which was causing havoc among emerging markets such as those of Latin America.
During March of 2020, financial conditions were extreme, policy makers provided support to the broad-based asset markets which in turn helped stabilize the gyrations in the currency markets. Direct and unilateral intervention is frowned upon by most nations and this view is reenforced by the likes of the IMF. Whilst policy makers will always reserve the right to intervene during market dislocations, currencies should be allowed to freely float because they are the balancing mechanism for both weak and strong economies, as well as an offset to poor policy decisions.
For the dollar, many other factors, such as interest rate and yield differentials, availability of quality collateral, domestic equity markets, foreign purchases of treasuries and the ebb and flow of the international eurodollar market, will remain the key currency determinants. Intervention is unlikely unless it is coordinated, and it would probably fail anyway. Yellen was merely making a bland statement about the reality of the US Treasury’s ability to impact its own currency.
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