That article I wrote was finally published. The hard copy should be out some time next week. I’m supposed to be getting a distributable pdf copy at some point that I will forward to you. The important takeaway from the article is to understand when the regime is about to change. “Understand the current regime we are in relative to the historical data and understand what regimes we are likely to progress towards.” We are a few steps from getting to a regime change now…
Remember the “Six Pillars of Long Rates”  article from last quarter? We are starting to see some shakier dynamics on most of the six pillars, each of which can be a driver of a minor regime change. Below is the current status of the six factors I discussed:
- ECB’s QE. We are about to go from €80 to €60 trillion in QE starting next month. More importantly, the data (both growth and inflation) has improved. We are about to go into the various European elections, Article 50 and Greece debt negotiations. However, once those pass and we get closer to the end of the year, people are going to be thinking about ECB QE tapering. Draghi was less dovish, and once some of the smoke clears, he may take another step towards being more neutral.
- BOJ’s QE. We have the BOJ meeting next week. They have been pegging ten year JGBs around zero. Now that US treasuries are nearing support levels, it will be interesting to see how the BOJ adjusts on a break. With all the cross-currency bond trading going on now, the BOJ will not be able to hold the Maginot line at 10bps for much longer IF the global bond market weakens. How they approach managing this limit should be interesting. What happens when a central bank owns four trillion dollars worth of ten year notes at 0% and rates pop 100bps? It’s not clear what the exit plan is going to be. You had an exit plan, right Kuroda-san?!? Let’s see if Kuroda follows Draghi and has also become less dovish.
- The Fed’s repurchases. We are now getting the “massive growth or inflation prospects” I said we would need for stopping reinvestments to be a factor in 2017. Getting to 1% FF this year looks like a near-certainty before the end of the year, and that is going to bring up the topic of what to do with repurchases. At the January meeting, “Participants also generally agreed that the Committee should begin discussions at upcoming meetings about the economic conditions that could warrant changes in the existing policy of reinvesting proceeds.” They will start to think about this next week. While they may be away from doing anything to this now, the markets know it may be coming.
- The neutral rate. I’m curious to see how the long run Fed dots have changed. It shouldn’t have changed much in theory, but if the (Fed) economists are just data-fitting, we could see the longer term neutral rate rise as the yield on the longer end rises.
- I still think the structural reasons for lower inflation are there. However, we have the potential for a supply disruption from any adverse trade policies, and the higher oil prices since last year (although lower now) are going to result in higher yoy prints.
- The peak of baby boomer births came in the 1950s. There were over 1 million more births in 1956 than 1976. So in the decades to come, there will be less need for fixed income hedging and more unwinding of (equity) assets to fuel consumption. We are still approaching the hump though, and still may need longer end fixed income.
As you can see, since I last wrote about the Six Pillars three months ago, the first five factors have unquestionably shown some cracks. This just makes the “regular” curve trading on Fed cycles more complicated. The natural inclination is to just look at the 2004-6 hiking cycle and see how the curve reacted in that environment. However, we did not have many of the above factors to take into account then.
The curve is going to be difficult to predict, because “typically,” the longer end of the curve flattens when a central bank gets more aggressive. However, because the longer end had rallied significantly in previous years from the Pillars above, it is not clear how the curve will change going forward this time around.
As a result, we have been doing more secondary and tertiary plays (on curvature). I have thought for some time that the low flies on the longer end of the curve offered good value in this environment. I have also have liked trying to flip low year spreads further out, with positive roll, potential cracks in the Pillars, and a “gradual” Fed. However, when we stop seeing “gradual” we need to be more cautious.