Last weekend, as Deutsche Bank's derivatives strategist Aleksandar Kocic was looking at the spread between the short and long end of the curve, and while contemplating the lack of market volatility, he concluded that "given where long rates are, Fed appears as overly hawkish – it has only two more hikes to go and, for volatility and risk premia to reprice higher, the gap has to widen. As is appears unlikely that the Fed will be cutting rates any time soon, the gap could widen only if the Long rates sell off."
In practical terms - if only for bond traders - this meant that "for anything to happen, 5Y5Y sector has to move higher", however the $2.5 trillion question is whether this sell off in long rates will be violent or controlled. Kocic concluded that "This is the catalyst for everything."
In other words, those lamenting the pervasive complacency and the ubiquitous lack of volatility in the market, may not have much more to wait: after just two more rate hikes, absent a parallel move wider across the rest of the curve, the Fed's "breathing space" will collapse, and Yellen, or rather her successor, will lost control of both vol markets and long-dated yields, as the Fed effectively hikes into a self-made recession, where it itself inverts the yield curve. That would be a problem.
Incidentally, among Wall Street's rates and derivatives strateigsts, the mixed - and polar opposite - signals being sent by the rates market has been all the rage in recent weeks, and everyone is eager to explain what happens next. For those who are unfamiliar, the conflicting dynamic sent by the bond curve is that "while the short end is optimistic, the long end has never been more pessimistic", in the words of BofA's rates strategist Shyam Rajan. And yet, in a paradoxical feedback loop, rarely has the near term meant more to the long term than today.
Here is how Rajan summarizes the "two-faced rates market", in which the 2s10s is so flat it is a clear warning that all else equal, a recession is approaching:
The rates market is sending diametrically opposite messages over the last few weeks. The front of the curve is increasingly confident about a Fed that will hike not only in December but at-least two more times next year. But, the flattening in the intermediate to long end of the curve is sending a clear end of business cycle message.
To say the least this is painfully confusing, because while the two can be squared off with a "hawkish policy mistake" message, "such an interpretation would not be consistent with the stock market reaching new highs or the dollar largely moving sideways this month" according to Rajan.
It's not just equities whose all time highs make no sense in light of this paradox: There is another notable problem with these divergent views about the future sent by the yield curve:
The problem with this disconnect in our view, is that rarely has the longer term outlook been more dependent on the short term - in fact, the next three months will provide us clarity on 1) The ability of Congress to muster the votes on the budget resolution and the possible tax reform bill 2) The outcome of the looming government shutdown on Dec 8 - and the possible leverage used by both the President and the Democrats over this key event risk 3) The geopolitical tension between US and North Korea aka the outcome of the key game of chicken outlined in this Cause and Effect.
The silver lining is that all of the above triggers - which are all critical regimes changers - will be unveiled soon enough:
Unlike economic data which has only a near term impact, the above three all have the potential to be regime switchers - tax reform moves us from a low r* to possibly higher r* world, geopolitics from low vol to high vol, and government shutdown from partisan politics to bipartisanship. Ultimately, we find it hard to believe that a Fed that is closer to its "perceived" neutral rate would hike several times before having some evidence that the neutral rate itself or inflation is going higher.
... Unless of course, the Fed is no longer concerned about the economic consequences from its actions, but merely eager to burst the stock market bubble, in which case should Yellen (or Powell, or Warsh, or Taylor) keep hiking until it inverts the curve, volatility is set to explode. Which, incidentally, brings us to the latest weekly note from DB's derivatives expert, the abovementioned Kocic, who picks up on his note from last week where as we pointed out last week highlighted that the Fed has 2 (at most 3) more rate hikes before it loses control. In logical continuation, Kocic asks "How much more can the curve flatten?" Here is his answer:
Although economic and political reality has not been lacking in excitement, the underlying uncertainties do not seem to convert into market volatility. Depressed long rates remain hostage to the long-term secular trends like demographics, global demand and potential growth, which is constricting the maneuvering space and gradually extinguishing risk premia across all market sectors. In rates, the playground defined by the gap between the long rate and near-term Fed expectations has shrunk to about 60bp. This means that there is room to price only two more hikes beyond what is already in the curve. The tightness of this gap is a function of the risk distribution which is forcing a gradual, but persistent, Fed.
In our view, the only way volatility and risk premia can return to the markets is if long rates sell off and free some room for the rest of the curve to start moving. The figure shows the history of the long rate and short term Fed expectations (Target or the Shadow rate) as extracted by our affine model. The long rate defines the upper bound for rate hikes."
Kocic concludes that exceeding this boundary "leads to unsustainable inversions of the curve. By hiking beyond long rates, Fed would stifle growth and reduce inflation expectations which would encourage the savings rate and withdraw consumption and investment." In short, the Fed could cause a recession...
Overly flat or inverted curve inhibits credit disintermediation and generally inspires forces that go against it. Investors are incentivized to borrow (and therefore pay) long term and deposit short term and receive higher rate,which tends to steepen the curve. In addition, in flat curve environment, lenders are reluctant to engage which would widen the spreads. In response, either the Fed cuts rates as a stimulus, or the curve itself bear steepens
Or perhaps not "could" but "would" the Fed be the catalyst for the next contraction (and bubble bursting). Which goes back to what we wrote over a month ago when we described what the real "$2.5 Trillion Question" is:
Is the Fed now actively seeking to launch the next recession (under president Donald Trump no less)? Perversely, it would make a lot of sense: with the business cycle now broken as a result of so much undue implicit reliance on asset prices, all of which are in a bubble - something which the Fed also understands - it would be beautifully symmetric that the same agent, the US Federal Reserve, that broke the business cycle and unleashed one of the longest, if artificial and on the back of trillions in central bank liquidity, economic expansion is now eager (and hoping) to be the catalyst for the next recession.
Or said simply, is the Fed now eager to accelerate the next economic recession in order to undo its own damage to a business cycle which has forgotten there should also be a contraction?
One month later, this remains the real $2.5 trillion question. No wonder everyone, not just bond traders, is so confused...