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Vince Foster: What the Current Bid for Duration Means for Investors


Last week's revelation that the savings rate has dropped and earnings didn't grow is likely one of the catalysts behind the bid for long duration assets.

From the Fed meeting on Wednesday to the close on Friday, the 30-year Treasury shrugged off a blistering employment report, rallying 3 points to push yields 15bps lower and taking the curve to the flattest of the recovery. By Thursday it became obvious that duration was in demand as the long bond rallied a full point on no news, which is the kind of move in front of such a big economic release that raises conspiracy theories. This bid for duration was confirmed on Friday after sellers tried to knock down the curve after a much better-than-expected NFP gain of 288,000 jobs -- only to find buyers who ripped prices to new highs. It was an explosive move that lit up my screen like a pinball machine.

No one has been able to explain the move, and participants are miffed. Instead of understanding why interest rates are falling, strategists are focusing on the Fed and trying to figure out when they're going to first raise interest rates. But what gets lost in the analysis is that the Fed is already exiting accommodation, and that's all that matters to the term premium in the yield curve. The reason duration is in demand is simple, but for some reason it's difficult for many participants to grasp.

I explained my theory on April 15 in Why Long Term Interest Rates Are Falling and May Continue to Drop:

The pain trade is in play but can be averted if the market begins to discount a higher growth rate in aggregate demand. However, this will require a big change in the current trajectory. If this doesn't materialize, the pressure on those short duration will be to extend duration exposure. As long as the 30-year yield remains below 3.50%, the pressure will intensify. 

The embedded bid for duration is massive, and I think this is grossly underappreciated. There are literally trillions of dollars sitting in the front of the yield curve, waiting on interest rates to rise. After Wednesday's FOMC meeting confirmed the status quo that exiting the QE stimulus campaign would continue, duration was well bid across the spectrum. The 3.50% level on the long bond held and there was no looking back. The duration grab was on.

The bid for duration is inflicting some serious pain as the relative yield pickup dwindles, with every basis point of curve flattening. This is where the pain trade gets its name. You don't want to buy at what looks to be a ridiculous level of interest rates, but you eventually capitulate at much more ridiculous levels. There's an important lesson in this market episode, and I think it's misunderstood. When it comes to the yield curve, there's a major difference between absolute yields and term risk premiums.

Just like there's a difference between volatility in prices and implied volatility premiums in prices, there's a difference between inflation and inflation risk premiums. The yield curve doesn't care about actual inflation: It cares about monetary policy inflation risk. Just as higher implied volatility prices can curb actual volatility, so, too, can high inflation premiums curb actual inflation. This is how the bond market discounts monetary policy. The yield curve acts as a counterbalance to monetary policy, tightening (steepening) when monetary policy is easy and easing (flattening) when monetary policy is tight. Inflation risk premiums drive the curve, and the curve drives absolute yields.

Monetary policy is tightening and inflation risk is falling -- and inflation risk is duration risk. With monetary inflation no longer a major risk factor and attention turning to a normalized level of short-term interest rates, investors now have an ability to price out the curve. Before the Fed's exit and with QE open ended, inflation risk was arguably exponential, which is why the curve was so steep. It's no wonder investors faded duration. With the Fed exiting (and, as we found out Wednesday, keeping their schedule for the first time in years), investors have inflation risk clarity, which translates into duration risk confidence. If I assume a 2% inflation rate, a 2% Fed funds rate, and falling inflation risk, I can price a fair value for long-term interest rates. This is likely what's happening.

Both the 30-year futures contract (15-year duration) and the 30-year Treasury yield found support at their respective .618 Fibonacci retracements. If this was an equity index, you'd assume that was a healthy correction prior to higher prices, but no one on the planet is forecasting new lows for long-term yields or believes it's even possible. While I wouldn't rule anything out, I don't think it's prudent to assume long-term interest rates are going to fall. That said, investors should prepare for the possibility that the curve is going to continue to flatten with the long end, anchoring around the growth rate of aggregate demand.

The media and econo-blogosphere love to focus on employment as it relates to Fed policy, but in terms of market-based interest rates, it's the growth rate in aggregate demand that matters. To the bond market, it doesn't matter if people are hired if they aren't paid. Absent credit growth, consumers can only spend what they make.  The 0.0% growth rate in average hourly earnings versus the estimated 0.2% was one of the employment report's more disappointing metrics.

Throughout the recovery, the year-over-year growth rate in wages has remained near a 2.0% growth rate; the growth rate in personal consumption has averaged 4.0%; and the growth rate in nominal GDP has averaged 4.0%. To maintain this growth rate in aggregate demand absent wage growth, consumers have dipped into savings, which is near the lows of the recovery. The bond market knows that spending with credit and savings isn't sustainable and that ultimately aggregate demand is a function of wages. Last week's revelation that the savings rate has dropped and earnings didn't grow is likely one of the catalysts behind the bid for long duration assets.

Going forward, the long end of the curve is going to anchor around the growth rate in aggregate demand. With wage growth stagnant, that suggests a sideways trend. Last week we saw some capitulation-type buying. Either the pain trade is climaxing or just getting started -- hopefully it's the former. Nevertheless, it's obvious that emotions are running high; there's a lot of fear of getting left behind and a lot of fear in buying the lowest coupons in history.

Expect big swings in both directions with volatile changes in sentiment from deflation to a breakout in growth. Don't get sucked into either extreme. As we progress through the summer and into year-end, it wouldn't surprise me to see 10-year and 30-year yields near where they began this volatile week -- at 2.65% and 3.45%, respectively.

Twitter: @exantefactor
No positions in stocks mentioned.
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