Let's keep this simple. The consensus is saying one thing. The bond market is saying something else. Who is correct? Let's examine.
The new rallying cry for Wall Street strategists is that the Fed is behind the curve. The belief is that the economy is accelerating, employment is improving, and the Fed's excessive easiness risks stoking inflation. To combat this economic improvement the Fed is likely to raise rates sooner than expected, surprising the market so long term interest rates should be rising.
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The bond market is not cooperating. Friday the 10-year closed at 2.48% and the 30-year closed at 3.29%, just off the respective low yields of the year. Not only are yields falling in the face of all this supposed economic improvement but the curve is massively flattening in a very hawkish manner. The bond market isn't trading as if the Fed is behind the curve on tightening; the bond market is trading as if the Fed is behind the curve on easing.
The list of those of us who have been fading the rising rate strategy is short. The problem with this bearish bias is there too much focus on the outright level of yields and not enough focus on the slope of the yield curve. It's the yield curve that is in command. On April 14 in "Why Long-Term Interest Rates are Falling and May Continue to Drop
," I explain how the slope of the curve interacts with monetary policy.
Historically the growth rate in reserves has been positively correlated with the slope of the yield curve. This makes sense. As the Fed creates reserves in excess of demand inflation, risk grows and the market raises the inflation premium by steepening the yield curve. As reserve growth slows, inflation risk falls and the slope of the yield curve flattens.
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As the Fed removes stimulus, the market is reducing the inflation premium embedded in the yield curve. I don't think there is any question that the growth rate in reserves has peaked, and thus the future bias of the curve should be flatter. The positioning bias is overwhelmingly short duration, and as this inflation premium is reduced, long-term interest rates are anchoring around the structural growth rate in aggregate demand.
The bond market is huge and its participants are not stupid. There is a perfectly logical and fundamental reason for long term interest rates to be falling. As the Fed was pumping in massive amounts of excess reserves, investors commanded increased inflation premiums by fading duration risk. Now that the growth rate of these excess reserves is falling, so too is inflation risk, and therefore investors are more comfortable with duration risk and thus are rolling out the curve.
The question for investors going forward is whether this bid for duration is sustainable, and if so how long it will last. While duration is not cheap, it's not as expensive as many presume and the closer the Fed gets to tightening, the more pressure will be on investors to rotate into duration risk.
The amount of money hiding in the front of the curve remains large and thus the embedded bid for duration is immense. You have to look no further than spreads in the mortgage market for evidence. Bloomberg's Jody Shenn noted this tightness in a piece on Wednesday.
In a market dominated by 30-year loans, buyers from banks to real estate investment trusts have piled into debt tied to 15-year mortgages offering greater protection against rising interest rates. More demand for the shorter-term debt caused yields in the securities to evaporate, with one measure of spreads over Treasuries narrowing to just 0.02 percentage point last month from more than 0.4 about a year ago.
The widely held assumption is that the Fed's purchases are influencing mortgage rates, but the irony is that it's the sector they are not buying that is the most expensive. This is because investors are hiding out on shorter duration 15-year MBS while they wait for the Fed to get out of the way. As the Fed reduces their participation in the 30-year MBS sector and spreads widen, investors in the 15-year sector will likely roll into 30-years. This rolling into duration will flatten the curve (sell short to buy long) ,and all else being equal will keep 30-year spreads and yields well bid.
As I noted back in February in Mortgages are the Tail Wagging the Dog,
since last year's 100 basis point rise in rates, mortgage origination has fallen off a cliff and thus the supply of MBS has been ever more scarce. Supply of agency MBS is on pace to be just half of the run rate since the financial crisis. Coming into the end of QE we have a situation developing where the demand for 30-year MBS debt is growing and the supply of mortgage origination is dwindling. Should investors be expecting interest rates to rise amid this supply/demand imbalance?
It's very possible this is what the yield curve is discounting. Absent the Fed increasing the supply of reserves and thus increasing inflation risk, the curve is going to reflect the supply and demand for credit. If the supply of credit was increasing in excess of the demand, the curve should be steepening. The demand for credit would be indicative of increasing aggregate demand in the economy and the market would be discounting a Fed that is too loose and behind the curve. The opposite is happening.
The performance of duration in the face of a perceived breakout in economic activity has been stunning. There is an overwhelming focus on the performance of the stock market as we sit at new highs, yet it's the long end of the curve that should be cheered. Year to date the 11/15/43 zero coupon treasury which at the time was the longest duration asset and the most sensitive asset to inflation, is up nearly 30% on the year, blowing away the S&P 500, which is up about 7%.
If the Fed was too loose and behind the inflation curve, the yield curve would not be flattening and zeros would not be outperforming stocks by a factor of four. In fact, the bond market is sounding the alarm that the economy is in need of the continued stimulus of lower interest rates.
We've seen this curve flattening in the face of stock market performance before and it always seems to get faded by the pundits just as it is today. The curve doesn't flatten because of a reach for yield or because investors want to buy 2.50% 10-year year coupons. The curve flattens to stimulate the economy. The curve flattens because the Fed is too tight. The curve flattens because inflation risk is low. The rules haven't changed.
No positions in stocks mentioned.