The Big Conversation
Episode 61: Is the Fed about to fight inflation?
This week we look at the rising risk of the Fed intervening to cap yields if they continue to march higher. Commodities are helping to support the inflation narrative, even though economic growth remains sluggish. It could be fatal for risk assets if yields move faster than growth. In the Chatter, we look at stocks which maybe more fragile than the headline performance suggests, with the recent decline in the VIX providing a second bite at protection trades.
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This is The Big Conversation, and we're looking at one of the biggest themes in the market - bond yields and how far they can go before risk assets react or the Fed intervenes. Long end yields continue to squeeze higher, driven by inflation expectations at a six year high. Now no-one minds a bit of healthy growth, but will the Fed need to initiate yield curve control if bond yields move higher at a faster pace than the economy?
Over the past few weeks, US 2-Year yields have hardly moved and have in fact tested their all time lows, suggesting very few prospects of an increase in short term growth. But the US10-Year is sending a very different signal having crossed the 1% yield threshold in January and continuing to steadily creep higher in response to the massive fiscal support packages now being proposed and debated in the US Congress. Ten-year Treasury yields jumped 10 bps last week to 1.21% - the highest since March of last year.
When 10 year yields have reached the top of the 40 year downtrending channel in the past, they have usually rung the bell for risk assets. Today those levels may seem far off, but the level of debts that have built up across the system over the last year could make risk assets sensitive to higher yields well before those levels are reached. Even yields on the German 10-Year bonds are breaking up and out of their channel and this steepening of the curve is driving the performance of cyclical assets such as euro zone banks and helping support the current perception of growth.
The Refinitiv Core Commodity Index has now recouped all the losses made since the beginning of the pandemic, with a number of star performers in the commodity space, including platinum at seven year highs and West Texas futures that are at pre-pandemic levels, despite global demand that remains well below those previous levels (and this is not withstanding some of the incredible localized moves in energy prices due to the extreme weather conditions currently being experienced in North America).
Commodities continue to follow the reflation narrative, and this uptick in inflationary pressure could become a global issue if it occurs without synchronized global growth, which many other risk assets are pricing in. The sheer scale of both government and corporate debt taken on by many of the G7 nations last year dwarfs anything seen in the past half century.
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Now the leader both in terms of amount of new debt borrowed, and the increase in government debt per capita, is America. The US budget deficit, at 15% of GDP, is the most extreme within G7. The new government debt burden in 2020 amounted to US$4.2tn, which was equivalent to a US$12,481 increase in debt per capita, according to the IMF’s net government debt estimates.
Other G7 countries saw large increases, though not quite as dramatic on a per capita basis. In the case of Japan, where gross debt-to-gdp ratios are already extreme (though far lower on a net basis), the increase was US$1.1tn or US$8,948 per capita. These estimates do not take into account the latest stimulus measures announced in Japan and America in December, never mind the bigger US$1.9tn now being proposed by the Biden administration or the considerable new fiscal expansion being undertaken in Europe. In the EU, the bloc’s four biggest economies, Germany, France, Italy, and Spain, committed to an extra spending of $3.1tn — a third of their combined gross domestic product — including vast loan guarantees, subsidies for millions of people’s wages and bailing out scores of companies, again according to the IMF.
The point is that globally, there is huge supply of government paper coming on stream, even though the US may choose to take some of the reserves from the Treasury Cash account rather than just issue new bonds. That might prevent excessive yields in the short run, but by it could legitimately increase inflation concerns because, unlike the selling of bonds, it’s not a cash call on the capital markets. The consensus about today’s expected higher inflation, however, is in stark contrast to recent history. We’ve had many inflationary scares in the past, all of which have turned out to be premature. Indeed, the U.S. Federal Reserve was markedly dovish, even before the pandemic. Almost 2 years ago, Federal Reserve Governor Lael Brainard said that the Federal Reserve would ensure that “equilibrium interest rates would remain low in the future” in order that they could “achieve maximum employment and price stability”. She called this the “new normal”, acknowledging “that inflation doesn’t move as much with economic activity and employment as it has in the past”. In practical terms it means that governments will push for higher employment levels without expecting an acceleration of inflation. Of course, that’s seemingly not a problem today given prevailing levels of employment in the US, and yet the market believes that a return to the pre-COVID status quo should create inflation pressures that haven’t existed for decades. It’s also worth asking whether it’s possible to have a sustained uptick in inflation when global activity is still extremely weak in many parts of the world.
Obviously there will be base effects on inflation given the declines in commodity prices during the depths of the pandemic, but the experience of 2008, where price declines were more dramatic, was one in which the rebound in inflation ebbed and flowed with the change in crude oil prices, but headline CPI barely reached 3% on a sustained basis. And we perhaps need to make the distinction between higher inflation and dangerously high inflation.
Admittedly, the impact of supply chain bottlenecks may accentuate the inflation effect this time around, but suppliers will adjust to higher prices, whilst on the demand side alone, literally thousands of small and medium-sized companies in places like Europe and the US have had much of their income wiped out and their business models upended. Higher inflation could be a fleeting event. The eurozone economy itself fell into a double-dip contraction in the final quarter of last year, shrinking 0.7 per cent from the previous three months, data published last week, resulting in a record postwar contraction of 6.8 per cent over the whole of 2020.
However, despite the difficulties of generating sustained inflation with monetary and fiscal policy, it's the market that matters in the short run. And what really matters to investors is what the market thinks today about inflation and not what CPI says tomorrow. If markets continue to fear that inflation lurks over the medium to longer term, then yields may well continue to rise. Over the last decade, markets have preferred weak growth and the promise of more stimulus, not strong growth and rising bond yields. So at what levels are yields likely to destabilize risky assets? And what is the Fed's risk tolerance to rising yields? They can't afford another misstep like the one at the end of 2018, when the S&P fell 20% after the US ten year yield hit 3.2% Could yield curve control be our future? There is historical precedent, but first of all, what is yield curve control? Similar to a policy rate, yield curve control aims to control interest rates along sections and points of the yield curve. The yield curve is usually defined as the range of yields on Treasury securities from three-month Treasury bills to 30-year Treasury bonds. Yield curve control generally targets longer term rates because the front end, say to 2 years, is anchored to the central bank’s key interest rate. Yield curve control is generally thought of as an interest rate CAP on particular maturities, although Japan introduced their 2016 target level on the 10 year JGB because yields had been falling too quickly. Generally, central banks who have implemented yield curve control will buy or sell bonds to keep yields at the target rate, as opposed to QE which usually targets an amount of assets to be bought over a given period of time.
Yield curve control is not a new policy. The U.S. incurred massive debts to finance World War II, and capped yields to keep borrowing costs low and stable. In April 1942, short- and long-term interest rates (and long term is 25 years and longer) were pegged at three-eights of a percent and 2.5%. As the U.S. continued to incur debts, the Fed had to keep buying securities to maintain those targeted rates—forfeiting some control of its balance sheet and the money stock. The public generally preferred to hold higher-yielding, longer-term bonds. Consequently, the Fed purchased a large amount of short term bills to maintain the peg, which also increased the money supply.
After the war ended, FOMC members grew more concerned with addressing the rapid inflation that had materialized. However, President Harry S. Truman and his treasury secretary still favored a policy that maintained yield curve control (which also protected the value of wartime bonds by implying a price floor). By 1947, inflation was over 17%, as measured by the year-over-year percent change in the consumer price index (CPI), so the Fed ended the peg on short-term rates in an attempt to combat developing inflationary pressures. But a combination of rising debt from the U.S. entering the Korean War in 1950, and the peg on longer-term yields contributed to faster money growth and another increase in inflationary pressures. By 1951, monetary policymakers insisted that they needed to combat inflation. Against the desires of fiscal policymakers, interest rate targeting was brought to an end.The US experimented with other forms of yield curve manipulation via a version of Operation Twist in the 1960’s, which targeted the sale of short term treasuries to drive up yields in order to attract capital into the US, whilst buying longer dated bonds to drive down yields in that part of the curve, in order to encourage private investment. Long term yields were remarkably stable during the first half of the 1960’s. In recent times, it’s the policy we mentioned earlier by The Bank of Japan that has been the trail blazer. They implemented YCC with the goal of exceeding its 2% inflation target. The short-term policy rate was set at -0.1% and the rate on 10-year government bonds was initially set at zero percent. Yield curve control complemented Japan’s quantitative and qualitative monetary easing and negative interest rate policies. This QQE policy, as it was called, resulted in annual bond purchases of about 100 trillion yen until 2016—sharply increasing the size of the Bank of Japan’s balance sheet. QQE with yield curve control lowered bond purchases to about 70 trillion yen in 2019. Additionally, the monthly inflation rate, as measured by the year-over-year percent change in the CPI, has remained above zero since enacting yield curve control.
Even more recently, the Reserve Bank of Australia (RBA) implemented YCC in 2020. Since its announcement on March 19th, the RBA purchased bonds worth 52 billion Aussie dollars to maintain the 0.25% target on three-year bonds. The bulk of purchases occurred between March 19 and May 6. The new policy has been very successful, with the three-year government bond yields trading consistently around 0.25 per cent since yield curve control was implemented. Meanwhile, the growing convergence of monetary policy with fiscal policy in America is dramatically highlighted by the trend in Fed balance sheet expansion, the annualised fiscal deficit (which is inverted here) and US M2 growth. That policy convergence is also symbolized by the appointment of former Fed chair Janet Yellen as Treasury Secretary in the Biden administration.
The above is not to say that America has now entered into a formal regime of direct monetisation, as advocated by the believers in Modern Monetary Theory (MMT). But so far the policy response has remained on a “needs must” basis in response to the perceived emergency circumstances created by the pandemic.
But all of the above highlights why the system in the G7 world cannot withstand higher interest rates, without considerable economic pain, and why there will be massive political pressure on G7 central banks not to tighten in any cyclical upturn.
That is also why the base case should probably be for yield curve control and financial repression in the US even in the face of a cyclical recovery. Going forward, the Fed’s role as market liquidity backstop could well ensure massive ongoing asset purchases – with constant risk of marketplace deleveraging and illiquidity, creating air pockets like we saw in equities last year, reflecting an increasingly unwieldy bout of Federal Reserve monetary inflation. Yield curve control may well be the only way to mask that and prevent yields reaching a natural clearing price, which given the imbalances and excesses, would surely be a lot higher if unchecked – or very destabilizing before they ever reached those clearing levels. Yield curve control could also have the impact of effectively “nationalizing” the bond market, if the Fed were to undertake a program as extensive as that of the Bank of Japan. Japanese Government Bond purchases have picked up again in Tokyo, as the Bank of Japan, which already owns 48% of outstanding JGBs at the end of 3Q20, has had to increase its JGB buying in response to the covid triggered stimulus of the government. Is this the kind of future that lies ahead for the US bond market? And if the bond market does come under effective government control, it could well mask underlying inflationary pressures in the economy, as the Fed continues to intervene to suppress increases in nominal yields. In this scenario, real yields would fall - that would be wonderful for debtors but terrible for creditors, with the obvious beneficiary being gold and its inverse relationship with real yields. Who will blink first, the Fed or the market? Policy makers have generally been reactive to risk-off events in asset prices or the economy – in the next section, therefore, we revisit a short term hedge for the current environment of rising yields and excesses that are building across many corners of the equity market.
In this section, we're going to look at an excellent hedging opportunity that we looked at earlier in the year, but it looked like it had passed because of the actions of GameStop. But since then, things have settled down and it's now come back and actually looks more attractive than it did a few weeks ago. Now, before we get there, I think we need to look at this incredibly rarefied equity market that we're in at the moment and some of the the historical activity that we're seeing behind the market. Now, first of all, in the options market, you've probably seen that volumes have gone to record highs. If we look at the Options Clearing Corp. Their total volumes in the US recently hit a one day volume of 50 million, and the average for this year is around about 40 million, and until last year, the average was about 20 million. So we double the volumes that we've seen over previous years for most of the last decade, in fact. Now, what's more impressive about all of this is that it's the type of players that are behind it, specifically and as we know, there's a lot of retail out there. And we know this because retail are playing in smaller sizes. So under 100 lots. So the number of 100 lot trades going through the market is very, very high. And the number of these as a percent of the New York Stock Exchange total equity volume is at a record level. And when we look at calls, so buying the upside versus puts, and this is calls to open as a buy, so this is individuals saying I'm going to buy a call option on a stock. These are also at record levels, so people are buying the upside rather than buying protection. So this is all about playing the upside in the market. And we're seeing this with a backdrop where the underlying equity market itself is also seeing some extremes. And GameStop was one example. But when we look at this chart of of the US most shorted stocks, it is Refinitiv's chart of the most shorted stocks. You can see that the most shorted stocks, so those that most people think are going to underperform, has significantly outperformed the S&P and that has particularly been aggressive over the last six months. So the least quality, the lowest quality stocks are outperforming. And this is really quite bad for capital because capital, instead of going into the highest quality names, is going into lowest quality names. At the same time, we've also seen a record short interest on the S&P. We recently got to the same levels that were seen at the peak of the dot com bubble in 2000. And at the same time, according to Sentiment Trader, we're seeing record low levels of cash sitting with mutual funds. So these are the funds that normally sit there holding cash that would buy dips. So if you've got a record low short interest, if you've got a record low in cash sitting at mutual funds, if you've got a lot of the short players who have been squeezed out of the market, then if we do get a rollover in the market, there are far fewer buyers out there to buy that downside. So the dip buying mentality is reduced by the very nature of this set up. Now, the reason why this is interesting is that prior to GameStop, I talked about the March expiry, March the 19th, and this was a great opportunity because as we've seen on previous occasions last year, into these quarterly expiries we've often seen a spike in volatility. We got one in March last year, then in June and then in September. We didn't get one in December. But then GameStop happened and it looked like we'd started to have the spike already. But since then, volatility has had that little peak and rolled over. And what we've seen is that the VIX, for the first time since the beginning of the pandemic, on a closing basis, has gone below 20. So the lowest level on a closing basis for nearly a year. And this is having been to that spike of sort of mid thirties only a few weeks ago. But also what we can look at is a comparison of the front month in volatility vs. a later month. So this is that sort of sense of, is the front month showing of the front months, are they low and therefore cheap relative to what the longer dated part of the market is pricing? So on this view here, we're looking at the second month VIX future versus the six month VIX future. And we can see here that that spread has reached the lowest level in the last 12 months and is pretty much at the lows of the last three years. This means that at the front end, you are seeing low levels of volatility. So it's worth looking at buying some hedges. And this is even more extreme when we look at the front month, the first month versus that six month. Now the reason why I haven't led with this is the front month is about to expire. So there is some impact of expiry on that. But we can see an extreme move. Front end volatility is cheap, but the back end is still worrying about risk. What we're talking about here is not necessarily a peak in the market, but what we are looking at is the potential for volatility to pick up as we head towards that March 19th quarterly expiry. Remember market makers who have been selling these options to those retail investors, their short volatility, their short gamma as we get closer to expiry, if the market continues to move up, that will put more upward pressure on prices, but then if it rolls over, the same impact on the downside. So we should expect gyrations in the market to pick up as we head towards the middle of March. So there's two ways you can look at that. One is you could buy protection so buying put's or if you've still got a bullish disposition, you could switch out of your long positions in the equity market and by some calls. Now really we're looking at calls at the index level, not at the single stock level, because single stock volatility is quite rarified because of what's been going on in things like GameStop. But certainly it looks like index level volatility in those front months is relatively good value on a historical basis versus the back end of the market. And now would be a good time to potentially reduce risk by either buying some protection or rolling out long positions. Buying calls, keep skin in the game, but if the market rolls over, then all you'll lose is your premium and you're sitting on some cash to buy those dips ie that's your powder that you keep dry for a rainy day.
And thanks for tuning in once again. And we look forward to seeing you next week where we'll be tackling more of the biggest themes in the market.