Yield Curve

"Balance-sheet wealth is sustainable only when it comes from earned success, not government fiat," is the ugly truth that former Fed governor Kevin Warsh (amazing what truths come out after their terms are up) and hedge fund billionaire Stan Druckenmiller deliver in the following WSJ Op-Ed. The aggregate wealth of U.S. households, including stocks and real-estate holdings, just hit a new high of $81.8 trillion. No wonder most on Wall Street applaud the Fed's unrelenting balance-sheet recovery strategy.The Fed's extraordinary tools are far more potent in goosing balance-sheet wealth than spurring real income growth. Corporate chieftains rationally choose financial engineering - debt-financed share buybacks, for example - over capital investment in property, plants and equipment. The country needs an exit from the 2% growth trap. There are no short-cuts through Fed-engineered balance-sheet wealth creation. The sooner and more predictably the Fed exits its extraordinary monetary accommodation, the sooner businesses can get back to business and labor can get back to work.

The recent decline in US yields appears to have run its course and given Citi's outlook for a better employment dynamic in the US, they expect yields to trend higher at this point. Citi's FX Technicals group remain of the bias that the normalization of labor markets (and the economy) will lead to a normalization in monetary policy and as a result significantly higher yields in the long run. Might the shock be that the Fed could be grudgingly tightening by late 2014/early 2015 (an equal time line to the 1994-2004 gap would suggest end November 2014) just as it was grudgingly easing by late 2007 despite being quite hawkish earlier that year? However, given the "treacherous market conditions" we suspect Citi's hoped-for normalization won't go quite as smoothly as The Fed hopes.

If predicting yesterday's EURUSD (and market) reaction to the ECB announcement was easy enough, today's reaction to the latest "most important ever" nonfarm payrolls number (because remember: with the Fed getting out of market manipulation, if only for now, it is imperative that the economy show it can self-sustain growth on its own even without $85 billion in flow per month, which is why just like the ISM data earlier this week, the degree of "seasonal adjustments" are about to blow everyone away) should be just as obvious: since both bad news and good news remain "risk-on catalysts", and since courtesy of Draghi's latest green light to abuse any and every carry trade all risk assets will the bought the second there is a dip, the "BTFATH mentality" will be alive in well. It certainly was overnight, when the S&P500 rose to new all time highs despite another 0.5% drop in the Shcomp (now barely holding on above 2000), and a slight decline in the Nikkei (holding on just over 15,000).

Borrowing heavily from Albert Edwards "Ice Age" analogy of our new normal, PIMCO's Bill Gross, after explaining why he does not have a cell phone, discusses the "frigidly low" levels of "The New Neutral" in this week's letter. Confirming Ben Bernanke's "not in my lifetime" promise for low rates and a lack of normalization, Gross explains that the "the new neutral" real policy rate will be close to 0% as opposed to 2-3% (just as in Japan) leaving an increasingly small incremental rise in rates as potentially responsible for popping the bubble. Gross concludes, "if 'The New Neutral' rates stay low, it supports current prices of financial assets. They would appear to be less bubbly," clearly defending the valuation of bonds knowing that he can't expose stocks as 'bubbly' without exposing his firm to more outflows.

Today you can’t go 10 minutes without tripping over an investment manager using the phrase “Minsky Moment” as shorthand for some Emperor’s New Clothes event, where all of a sudden we come to our senses and realize that the Emperor is naked, central bankers don’t rule the world, and financial assets have been artificially inflated by monetary policy largesse. Please. That’s not how it works. That’s not how any of this works.

It seems shorts keep covering and the Chinese keep buying (through Belgium of course - as they sell CNY, buy USD, and grab the extra yield on Treasuries). Despite stocks relative stability, 10Y yields have just hit 2.40% for the first time in over 11 months (as USDJPY broke down). It seems this morning's dismal GDP print was just enough to confirm the growth/inflation slowing meme (in bond investors' minds) and the yield curve is flattening even further...

Wednesday is not Tuesday (except for Trannies). Some early weakness in stocks was bid mindlessly back to its highs even as 10Y bond yields kept tumbling to 11-month lows and oil and copper rolled over. VIX ended the day higher (again) ignoring the exuberance in the light volume equity market. 10Y yields dropped to 2.43% - its best day in 5 months (breaking last October's key support). The yield curve flattened dramatically with 2s30s at its tightest in a year. The USD was bid (led by GBP weakness) buy JPY's volatility is what ran the stock show today. Gold and silver fell further as did WTI crude (back under $103). The S&P 500 is now around 60 points rich to 10Y bond yields (and the world is still short bonds); credit spreads are well off their tights and VIX isn't falling; breadth is weakening and so is volume... but apart from that... BTFATH. A late-day selling frenzy took the shine off the CNBC headlines with stocks closing red.

Could this be the last straw?

A steep yield curve induces investors to borrow at cheap shorter rates and buy riskier assets to earn a spread.  Party on while the Fed provides the punch bowl.  Maybe this time the volatility will come even before the Fed eases off the pedal?

30Y US Treasury yields have retraced more than 50% of the Taper Tantrum and weak data this morning once again pressures yields to new lows. 10Y now trades 2.5009%, 30Y breaks to fresh 11-month lows at 3.31% as the yield curve is flattening notably once again. European peripheral bonds are having their worst day in a year (as we noted earlier) and US and European equity markets are stumbling.

In this brave new centrally-planned world, where bad is good, very bad is very good, and everything is weather adjusted, Japan's blistering GDP report last night, printing at 5.9% on expectations of 4.3% was "bad" because it means less possibility for a boost in QE pushing futures lower, while the liquidity addicts were giddy with the GDP miss in Europe where everyone except Germany missed (as for the German beat, Goldman's crack theam of economic climatologists, said it was due to the weather), and the Eurozone as a whole came at 0.2%, half the forecast 0.4%, which in turn allowed futures to regain some of the lost ground.

That greatest contrarian indicator in the history of finance, Tom Stolper (arguably even better than Dennis Gartman), may no longer be at Goldman but his muppet-crushing spirit lives on. With Bund (and Treasury) yields tumbling to lows not seen since mid 2013, adding insult to injury, and accelerating the short squeeze, here is Goldman's Francesco Garzarelli with "Trade Update: Close Trade recommendation selling short Euro Bund June 14 futures (RXM4), for a potential loss of 2%."

Cruising through earnings, it is now time to revisit certain indicators that speak to the underlying health of the economy and that of the US equity and Treasury bond market.

In this difficult market, and confusing - for traders, and everyone else - environment, what are the three main questions posed by Goldman's clients had? According to David Kostin, "Three questions dominated our investor dialogue this week given the lack of meaningful data releases.

1. Interest rates: The recent decline in ten-year US Treasury yields to 2.6%, the forward path of interest rates, and implications for equity valuation;
2. Capex: the outlook for corporate capital spending in 2014; and
3. Rotation: The potential for the momentum drawdown of the past two months to reverse and vault high expected sales  growth companies back into a market leadership position.

The long-bond yield is now up 10bps on the week (and 5Y -4bps) leaving the yield curve steepening by its most in 20 months. Thanks to a handy - we don't need no stinking protection - VIX slam, US equity markets have recovered to highs of the day as the buying panic of yesterday is replayed once again.