The Weekly Beat: 2 January 2023
Front-Loading, Enter the Shogun, Egypt Rising
U.S. Bond Markets
· The U.S. yield curve continued steepening last week, continuing a trend started at the most-recent FOMC meeting, but the Fed remains in problem territory (Charts 1 & 2). Money markets are not expecting further tightening so at best FOMC members might be able to “talk up” rate expectations to the current 3-month rate (Chart 3).
· The yield curve could right itself if market participants believed further rate increases are coming - at a slower rate - and that the Fed can keep the policy rate high enough for it to matter for bonds with maturities over ten years.
· Given that the Fed is one percentage point short of its view on terminal rates and fears of recession abound, it seems unlikely a scenario could occur that justifies ten-year rates above five percent based purely on the expected future path of the overnight rates. Indeed, the BIS bulletin on “front-loaded” tightening noted that in cases where central banks rapidly raise rates the policy rate stays at its peak for a very short time and then falls rapidly.
· The reason rates typically come down so quickly after a rapid tightening is that a recession occurs and - based only on the term spreads along the curve - a recession in 2023 does look likely. However, single indicators clumsily applied rarely make for good forecasting.
· Banks remain the primary source of credit in the U.S. economy and, due to the Fed’s operating methodology of “abundant reserves”, the funding cost for banks is largely disconnected from the Fed’s policy rate. This was by design after the 2008 Financial Crisis with the desire to have banks rely on more stable deposit-based funding. The upshot is that the Fed lost control of bank profits for maturity transformation. Each time the Fed raises the policy rate, and the Prime Rate follows, credit creation gets that much more profitable for banks (Chart 4).
· To raise the policy rate further without badly distorting financial markets, the Fed will need to prop up the back end of the curve. Running down the balance sheet via maturities is having the negative effect of boosting the front end of the curve (Chart 5). The Fed is sitting on a mountain of assets and cannot realistically become a net seller of Treasuries without triggering a financial crisis (Chart 6). Yield Curve Control will be the solution.
· Real interest rates have reversed since the December FOMC press conference, but this writer does not expect them to resume a downward trend until a policy intervention occurs (Charts 7-10).
· Credit conditions have remained strong for investment grade issuers as spreads remain tight (Chart 11). However, investment grade bonds underperformed Treasuries and high yield in 2022 (Chart 12). The combination of lower liquidity than Treasuries and lower yield than high yield bonds made investment grade the big loser in a rising rate environment.
· Gold continues to hold up against rising real rates and has comfortably passed the $1,800 congestion level (Charts 13 & 14). With prices approaching an upward wedge, a downward move in real rates could provide the bid needed to get to the next congestion zone just below $1,850.
G-7 Bond Markets
· The yield curve in Japan continued to react to the BoJ’s new iteration of Yield Curve Control. The BoJ is attempting to shape the entire yield curve, rather than simply setting anchors at the policy rate and ten-year maturity. The goal is to strengthen the yen and likely represents a new regime of competitive currency appreciations.
· The yield curve in the UK is laid out flat as bond markets watch the Bank of England for signs of a policy error. Andrew Bailey will continue walking on eggshells to avoid a policy error that will tank the domestic economy while also avoiding a second bond market crisis. Fortunately, the BoE is the most reasonable of the central banks and has admitted the need to proceed cautiously for lack of clarity.
· In Canada the yield curve remains deeply inverted, despite getting some help from the Fed with long-term yields. Money markets appear to be pricing in more rate increases, but at a tepid pace and small. Absent a recession in the U.S. the outcome in Canada will largely swing on the damage done by housing market collapse to bank balance sheets.
