Yield Curve

There’s more than a whiff of 2008 in the air. The sources of systemic financial sector risk are different this time (they always are), but China and the global industrial/commodity complex are even larger tectonic plates than the US housing market, and their shifts are no less destructive. There’s also more than a whiff of 1938 in the air, as we have a Fed that is apparently hell-bent on raising rates even as a Category 5 deflationary hurricane heads our way, even as the yield curve continues to flatten.

The risk of a fracture in risk markets when lower liquidity meets forced selling, is high in our view. Should this weakening of spread sectors in fixed income continue, we will see a further rally in Treasuries – back in Aug/ Sep, 10y USTs broke below 2%, and there is no reason we can’t get there later this month.

The Treasury yield curve has collapsed since Janet and her band of inverse Robin-Hoods hiked rates into the worst earnings and manufacturing recession since the crisis. In fact, the spread between 2Y and 10Y rates has plunged 15bps since December's FOMC meeting to its flattest since 2008... so we ask simply - Dear Janet, please explain?

Yesterday JPM, which despite calling for a 2,200 year end price target, paradoxically warned that the regime of "buying dips" is over, and that "we take the view that equities are unlikely to perform well on a 12-24 month horizon" adding that "the regime of buying the dips might be over and selling any rallies might be the new one." So don't buy dips yet somehow the S&P will rise 150 points? Fair enough. Today, it is Citigroup's turn to try to somehow predict both a 12% "gain for global equities in 2016" even as it tells clients to start selling US stocks because "fading EPS momentum and rising Fed funds mean that, after 6 consecutive years of outperformance, we cut the US to Underweight."

Away from the endless chattering of talking heads proclaiming that "they do not see any recession on the horizon" despite the manufacturing segment of the economy collapsing, JPMorgan notes that in fact the three best leading indicators for recession are: Credit spreads, yield curve shape, and profit margins. Unfortunately for The Fed and its congregation, JPM warns credit spreads are not giving a positive signal.

Another possible step would be to reduce short-term interest rates below zero if needed to provide additional accommodation... Could negative interest rates be a policy response that the Federal Reserve could choose to employ in a future crisis? ... these are transitional problems, but they might be sufficient to make a move to negative rates difficult to implement on short notice.

We believe the Credit Cycle has turned and with it will come some massive unexpected shocks. One of these will be the fall out in the Bond Market, centered around the dramatic growth explosion in Bond ETFs coupled with the post financial crisis regulatory changes that effectively removed banks from making markets in corporate bonds.  It is a ‘Witch’s Brew’ with a flattening yield curve bringing it to a boil.

The prospect that the leaders of our monetary politburo are about to be tarred and feathered by economic reality might be satisfying enough if it led to the repudiation of Keynesian central planning and a thorough housecleaning at the Fed. Unfortunately, it will also mean that tens of millions of retail investors and 401k holders will be taken to the slaughterhouse for the third time this century. And this time the Fed is out of dry powder, meaning retail investors will never recover as they did after 2002 and 2009.

If at first you don't succeed, try, try, keep trying again and again. That appears to be the mantra of Goldman's credit strategists.

My overriding theme and the central drama for the coming year is that unexpected events can take on greater importance as the Federal Reserve ends its near-decade-long Zero Interest Rate Policy. Consensus premises and forecasts will likely fall flat, in a rather spectacular manner. The low-conviction and directionless market that we saw in 2015 could become a no-conviction and very-much-directed market (i.e. one that's directed lower) in 2016. There will be no peace on earth in 2016, and our markets could lose a cushion of protection as valuations contract. (Just as "malinvestment" represented a key theme this year, we expect a compression of price-to-earnings ratios to serve as a big market driver in 2016.) In other words, we don't think 2016 will be fun.

It becomes ever more tempting to conclude that the timing of the Fed’s rate hike was really quite odd, even from the perspective of the planners...

The Fed seems to have been operating on the theory that their own views on the economy determine its path. But recently the Fed has taken the principle to an extreme never seen. Yellen may well have just hiked rates expecting, hoping, that the mere act of showing confidence in the economy would produce an economy worthy of confidence. The Fed has dominated the narrative for years now, investors and traders hanging on every word. Last week that started to change, the market repudiating the Fed’s outlook over a 48 hour period that must have produced some second guessing at the Fed.