Via Scotiabank's Guy Haselmann,
The Fed has purposefully tried to engineer a later lift-off beyond what it normally should have been -- due to the extent of the crisis. However, they risk losing credibility as the market is questioning just how behind the curve they are. A growing group of investors is worried that the Fed is blind to the aggregating risks to financial instability.
The interesting contradiction is that the market believes the Fed should have tightened already, yet interest rate futures have priced “lift-off” probabilities beyond September. This incongruity in interest rate futures stems from the market’s perception that the majority of FOMC members are Doves who rely too much on models and will thus stay accommodative. The ZLB simply does not afford the Fed the option of rising too soon or they believe they will undo much of the progress that they made (and would have no bullets to fix that mistake).
Unfortunately, Fed models are incapable of measuring extent and costs of financial instability – something Mester admitted and emphasized last week.
The FOMC likely recognizes that there will be a ‘market reaction’ when rate “lift-off” finally arrives, but there are many (including myself) who believe the Fed is under-estimating the degree of that ‘market reaction’. Fed worries are suppressed, because they believe they have “macro-prudential” tools: a talking point that few in the market have understanding what it really means. Regardless, those tools do not prevent market disruptions, but merely help to pick up the pieces once the market’s reaction gets bad enough.
The front end of the bond curve needs to price in a Fed that likely to hike in June. This is occurring (after today’ employment report) and thus shrinking the divergence between the Fed warning about June “lift-off” and the markets skepticism.
The curve is steepening today as long maturities are battling between two cross winds (explained in a moment). Yet, the upward pressure on long yields could be short lived to this week and early next (supply), while the downward pressure on yields may be a slower moving and on-going theme.
Yields are being pressured higher by a historically large corporate issuance calendar (above $60 billion this week alone) and the perception that the Fed is behind the curve -- particularly after the ECB’s action and numerous other global central bank easing moves in 2015.
On the other hand, yields are being kept lower than they would otherwise be, due to low global bond yields and an appreciating US dollar trend which makes Treasuries very attractive to foreigners on a relative basis. In addition, yields are low due to hoarding of long-date securities by central banks which is creating a shortage of high-quality highly-rated sovereign bonds. Regulatory rules have also required banks to hold more of them. Therefore, it is difficult to price the value of long-dated Treasuries when they have qualities of a commodity whose demand is arguably greater than the supply.
I still like the flattener and believe the market is providing an opportunity to get into the trade at better levels (than recent levels). I like the flattener in Europe (even more than in US). I believe several 2’s 10’s curves in the EU are likely to go to ZERO. The CB’s implementing ECB QE will want to buy positive yielding securities. Even though the cap is -0.20%, they are unlikely to buy negative securities. As the shortage of willing sellers gets scarcer, I believe rates will attempt to grind toward 0%. German 2’s yield -0.21% (below the cap), while 10’s yield 0.0.34%. I can envision this curve at zero even as economic data in Europe is better than expectations. A flattening curve in Europe would place flattening pressure on the US curve as well.
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On a separate note there is another factor that may arise going forward. During the last several years of uber-accommodation by the Fed, both stock and bond prices rose. It would not be surprising if both fell in price as the Fed proceeds with a June “lift-off”. However, stocks might be the worse of the two performers. I expect rising market turbulent and expect a terminal fed funds rate of only 0.75%-1.00% into mid-2016. The Feds balance sheet has $400 billion of maturities to deal with in early 2016 which the market place is not paying enough attention to. I believe the Fed will want to allow as much of this as possible to roll off (i.e. the balance sheet will shrink). The decline in the Feds balance sheet is a defacto tightening. The Fed may be reluctant to do both, i.e. hike, while also allowing the balance sheet to shrink too quickly. They could hike and do some re-investment, but it may be strange re-invest a large portion at the same time that they are hiking. I believe market turmoil and balance sheet maturities will cause a period of (hike) pauses in 2016. If this is true, Treasury market yields may not rise as high as some pundits are warning.
In a sense, markets are now beyond the control of the Fed. They were able to change investor behavior for a few years, but the herd mentality is now becoming dislodged: “lift-off” could possibly cause a steep reversal. I expect SPX to dip below 2000 by the time of the March 18th Fed Meeting. A ‘market reaction’ to pivoting policy is likely expected by the Fed, but SPX at 2000 would not enough to change its actions. How investors and asset allocators behave is the question.
Moreover, for stocks, rising bond yields will end the conversation about multiple expansion in US equities. Higher yields will also slow share buybacks, as corporate issuance to fund buybacks will dissipate. The shift in rate hike expectations is also accelerating the bid in the USD which will hit corporate earnings. Therefore, while equity prices and short maturity bonds prices could both fall, if the decline in equities falls too far too fast, then there would likely be flows into Treasuries until equities stabilize.
I expect the Fed to tighten in June and the Treasury curve to flatten. Carry and rolldown, relative yield attractiveness, the effects of ECB QE and the various other factors outline above and in prior notes will provide underlying support for Treasury prices. Should equities tumble too far too fast, all Treasuries yields across the curve would fall (and maybe materially) from today’s current prices.