Some of the FOMC members have been saying they don’t want to invert the yield curve, but sections of the ED yield curve have already inverted. For the past few weeks, EDH0-H1 spread through EDZ0-Z1 has been negative. I think this will be a permanent feature of the yield curve going forward, barring some miraculous appearance of the term/risk premium. There are a number of reasons for this:
- The Fed statement. The Fed took out the forward guidance that implied that they would stay accommodative. In theory, as long as the Fed stays accommodative, the longer end of the curve would have to be steeper. That is the definition of accommodative – lower rates in the short term than would otherwise be required in the longer term. They were expected to remove forward guidance as we got to “neutral,” however the removal of the guidance (early) may make it more likely the Fed overshoots…
- The Fed dots. The dots also show a noticeable overshoot. When you raise rates above the longer term average, you will eventually have to lower the rates back. That lowering of rates at some point in the future causes a degree of curve inversion. The latest set of dots shows about a 44bp inversion between the 2020 dots and the longer run dots. Words can not describe the colossal stupidity it would require to hike two 25bp increments more than the longer run average (under current conditions), as per the current projections. It’s mind-numbing that every Fed seems to want to hike until recession, all because of some mythical inflation boogey man. I know we had inflation in the 70s. But back then, the demographics supported that. Now the demographics are going to other way. You might as well tell me that to land a plane, you need to aim 44 feet below the surface of the runway. I liked it better when they were going to be slightly accommodative and have the currently slow economy just coast to target.
- The ECB. The ECB being on hold for a year is going to cause the markets to gravitate towards carry trades. The EU also has to worry about Italy, Greece, Turkey, US tariffs, and Brexit. None of those things are going to get resolved quickly. While the US is not the EU, the global financial markets are linked and low EU rates could put downward pressure on US rates (all other things being equal).
- The market bulls. If you are a market bull, you are more likely to want to buy the long end – for both carry and because you think the economy will eventually lead to recession. You’ve probably heard the “end of cycle” arguments from a lot of analysts. Other reasons bulls want to buy the long end include things like demographics, low structural inflation, foreign central banks, CFTC short positioning, trade wars, EU instability, etc. This is going to put downward pressure on ten year yields and the back greens.
- The market bears. If you are bearish, you are probably thinking the Fed hikes 4 times this year and 3-4 times next year. That gets us to about a 3.25 FF target rate at the end of 2019. While it’s possible the longer end follows suit, there’s a reasonable chance it doesn’t. So if you are a bear and had to pick a part of the curve you wanted to short, are you going to pick the long end (that may or may not follow suit), or are you going to pick something in the reds, that will converge to your Fed target rate? Exactly! And if you are a rates bear, you are probably more likely to think the Fed could overshoot, and like curve flatteners.
- Kong may be doing just that – expressing the “Fed hikes 3-4 times next year” view. He is keeping the reds better offered to the rest of the curve, than would normally be the case. While it is possible that a Kong unwind could cause a slight steepening between reds and blues, it is less likely for an unwind to occur this quarter. Even if Kong does unwind, I think his effect on something like year spreads further out may only be a couple of basis points.
Weighing all of the above, it’s understandable that the reds-greens part of the curve is going to invert. Looking at the very near-term, it’s not clear that we’ll get anything to change the current market thinking. The major things that could change the current inversion are:
- Higher growth. In particular, a favorable trade deal that is seen to spur US growth could cause a Trump election style selloff in the long end. This is possible – probably not in the very short term. The more likely scenario would be a more modest and “fair” trade deal. It is not clear that a weak deal would be enough to steepen the curve back out.
- Longer end liquidation. Many a trader has gone broke playing for this. You would think that the end of Fed QE and larger fiscal deficits would have caused people to stop buying the long end. Nope. Maybe the ECB or BOJ will have a change of heart. But that’s not going to happen any time soon. And don’t even mention China. Even if China hates us, why would they lose money by liquidating? The more likely scenario is that China stops reinvesting if they hate Treasuries.
- The return of the term/risk premium. I’m going broke trying to play for this. If we are going to see Gundlach’s 6% tens, we need to see some premium at the back of the curve. But the insurance companies, pension funds, foreign entities, etc. continue to buy and drive the premiums negative. I may as well be looking for unicorns.
Let’s keep the above in mind when looking at longer-end trades.