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The bond market says ‘meh’



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Welcome back. The week is about over, and I promise next week we won’t talk about inflation at all. I really mean it this time. But today we will.

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Why higher inflation is being ignored

The consumer price index came in a bit hotter than expected on Thursday, with core inflation at 3.8 per cent, but government bond yields didn’t move. In principle this is a little weird. Inflation is bad for bond prices, so it should drive yields up. But bonds indifference is not unexpected. Bond yields peaked back in March. Since then the story has been “look at the 10-year note, it says inflation will be transitory, everything is cool” or alternatively “look at the 10-year Treasury, it says that investors think inflation will be transitory, but boy are they in for a surprise, buy canned food and guns”. 

I am closer to the former camp than the latter. Once again, most of the stuff that drove the index up in May was stuff that the pandemic crushed, including hotel rooms, or created bottlenecks in, such as cars. Capital Economics had a tidy chart of the hot categories: 

All of that should be transitory. But we cannot quite relax. Three comments on why not.

First, not absolutely every category that is heating up can be dismissed as a natural consequence of the reopening. Housing costs (“owner-equivalent rent”) which rose at an annualised rate of more than 4 per cent was one example. It’s not a crazy number (“so far there is a normalisation, not a surge”, Strategas wrote in a reassuring note). But it makes me want to see what next month’s number looks like. 

Second, there is a lot of price-insensitive demand for US sovereign bonds, which may prevent yields from responding to inflation fears. They are the most liquid of assets, used for all sorts of purposes other than maximising returns. They are a safe cash alternative and a form of collateral for just about everyone, everywhere. 

An example. My former colleague Tracy Alloway, now at Bloomberg, had a nice article this week about increasing demand for US Treasuries at banks, which are required to hold a bunch of very liquid, safe paper. Collapsing yields on the other options have shifted bank demand toward Treasuries, and banks have bought hundreds of billions of them in the past year or so. 

On top of that, remember that US Treasuries still yield a lot more than other sovereign bonds. Japanese bonds yield basically nothing. German ones have a negative yield. So if you have a safe sovereign bond allocation that needs filling, what are you going to fill it with? 

And, oh yeah, on top of that, the Federal Reserve is buying $80bn of Treasuries a month. That is almost half of the net issuance over the past 12 months, on data from the Securities Industry and Financial Markets Association, or about 4 per cent of the outstanding stock of Treasuries. As the trader who tweets as Five Minute Macro summed it up: 

“The Fed is knee-deep in the bond market at every maturity, but people still want to parse what every wiggle and jiggle in the bond market says about the economy or investors’ expectations. Combination of old habits dying hard and the alternative being rather nihilistic.”

I mean, if the 10-year Treasury yield doesn’t tell us much, what the hell am I doing for a living? But, anyway . . .

Lastly, we have a perfectly simple explanation of what is going on, which is that inflation fears’ effect on yields are being masked by falling real rates. Here are market-derived inflation expectations for the five years starting five years from now, plotted against the 10-year yield (data from the Fed): 

To simplify, inflation expectations can go up while yields stay flat because the inflation-adjusted return that investors demand on the money, the real interest rate, is falling.

I wrote about real rates yesterday. Thinking about it since then, it occurs to me that a very low and falling real interest rate is hard to tell from investor nihilism (“the return on everything stinks, I’ll settle for anything with a tiny bit of yield, going to cash and waiting for something to happen will get me fired, is it drink time?”) but that is an issue for another hour. 

Banks and cryptocurrencies 

The Basel Committee on Banking Regulation thinks that banks that hold cryptocurrencies should keep capital equal to the full value of those digital assets. In Basel-speak: “Capital [should be] sufficient to absorb a full write-off of the cryptoasset exposures without exposing depositors and other senior creditors of the banks to a loss.” 

This makes perfect sense, and makes crypto a terrible business for banks.

It makes sense because cryptocurrencies (except for those tethered permanently to more stable assets, which Basel has excluded from the heavy capital demands) are wildly volatile. Bitcoin lost almost half its value in a few weeks in May for no apparent reason. A bank can’t go around putting leverage on something that behaves that way. 

This is obvious, and is in addition to technological or criminal risks associated with crypto (“cryptographic key theft, compromise of login credentials and distributed denial-of-service attacks”).

But banks make basically all their money from leverage. Their return on assets is about 1-2 per cent, they lever that 10 times or so, arriving at a return on equity that is barely higher than their cost of capital. They look like they make a lot of money in the good times, but that’s an accounting illusion. Across the cycle it’s a pretty tough business. Assets that cannot be leveraged don’t fit the business plan, at least not at any scale that matters.

This is not a criticism of bitcoin or crypto assets generally. And it shouldn’t bother crypto-believers much. A key part of the pitch for crypto is that it will allow users to tell the government-controlled system of banking and money to buzz off. If that system wants crypto to buzz off too, well, everyone should be happy. Bitcoin didn’t move much on the news from the committee.

The Financial Times did, however, find a banker willing to say on background that the committee has it wrong:

“We’ve all seen what happens when you drive activity out of a pretty well-regulated system into the wild west . . . Do the regulators want the adults to do the business, or would they want the teenagers to do the business?”

This is a hilariously bad argument (“If you don’t let bankers smoke crack, who is going to smoke all the crack? The children!”). Yes, we do want crypto to be handled in some sort of self-contained system where, if it blows up, we don’t need to hold a mortgage-bond fire sale to fill the hole the explosion left behind. The interesting question is how that self-contained system should be regulated, taxed and so on.

One good read

The FT’s Martin Sandbu thinks there is no labour shortage, no widespread wage pressure and no sticky inflation. He backs his argument with plenty of data and sound logic. Read his column if you are feeling panicky.

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Bond spreads collapse as investors rush into corporate debt




The premium above super-safe US Treasuries that investors are demanding to buy corporate debt has dropped to its lowest level in more than a decade.

The collapse in the difference between yields — or spread — is a sign that investors are growing increasingly confident that recent rises in inflation will not hinder the booming economic recovery.

The spreads between US Treasury and corporate bond yields have tightened markedly this year, as investors gained confidence and clamoured to own even marginally higher yielding assets in a low return world.

That spread compression, which indicates the level of risk investors see in lending to companies compared to the US government, had come under pressure from the spectre of higher inflation from mid-April to May.

However, an increasing number of investors are coming around to the Fed’s mantra that price rises will prove transitory as the economy reopens after the pandemic, pushing measures of expected inflation lower.

“The Fed has been controlling the transitory narrative which has provided confidence to corporate bond investors,” said Adrian Miller, chief market strategist at Concise Capital Management. “After all, corporate bond investors are more focused on the expected strong growth path.”

Line chart of Spread on US corporate bonds, by rating (percentage points) showing Investors are demanding less yield to lend to US companies

Confidence in the economic recovery was further bolstered on Wednesday as Fed officials signalled a shift toward the eventual repeal of crisis policy measures, embracing a more optimistic outlook of America’s rebound. The more hawkish tone from Fed chair Jay Powell — including comments that “price stability is half of our mandate” at the Fed — has helped to mollify concerns that inflation could run out of control, forcing a more abrupt response from the central bank.

The spread between US Treasury yields and investment grade corporate bond yields fell 0.02 percentage points to 0.87 per cent on Wednesday, according to ICE BofA Indices, its lowest level since 2007, and was unchanged on Thursday. For lower rated — and therefore riskier — high-yield bonds, the spread fell 0.05 percentage points to 3.12 per cent, below a post-crisis low last set in October 2018. It widened modestly to 3.15 per cent on Thursday.

The slide in spreads has been buoyed by the central bank’s accommodative policies through the pandemic crisis as well as the federal government’s multitrillion-dollar pandemic aid package. Financial conditions in the US are close to their easiest on record, according to a popular index run by Goldman Sachs, which has spurred a wave of corporate borrowing by riskier junk-rated businesses.

Some 373 junk-rated companies have borrowed through the nearly $11tn US corporate debt market so far this year, including companies hard hit by the pandemic like American Airlines and cruise operator Carnival. Collectively the risky cohort has raised $277bn, a record pace and up 60 per cent from year ago levels, according to data provider Refinitiv.

Column chart of Annual proceeds from high-yield US corporate bond sales ($bn) showing Risky junk-rated US companies are issung debt at a record pace

However the fall in spreads and investors’ perception of risk has not been enough to outweigh an overall rise in yields, which have been jolted higher by the prospect of rising interest rates as investors adjusted to a quicker pace of policy tightening from the Fed.

Higher rated debt, which is safer but offers less of a spread to cushion investors against a jump in Treasury yields, tends to suffer more in high growth, rising interest rate environments. High-yield bonds on the other hand tend to benefit, with the booming economy making it less likely that companies will go bust.

“For the time being people are not at all fearing the price action of a move higher in yields,” said Andrzej Skiba, head of US credit at BlueBay Asset Management. “Companies are doing really well and we are seeing a meaningful recovery in earnings.”

Investment-grade bond yields have moved 0.3 percentage points higher to 2.08 per cent since the start of the year, compared with a decline of 0.27 percentage points to 3.97 per cent for high-yield bonds.

Bank of America analysts expect the two markets to keep coming closer together, projecting that investment-grade spreads will widen to 1.25 per cent and high-yield bond spreads will continue to decline to 3.00 per cent in the coming months.

However, while optimism about the US recovery abounds the continued zeal for lower-quality corporate debt has caused consternation in some quarters. Investors worry that precarious companies are being offered credit at interest rates that don’t account for the high levels of risk involved.

“It’s very important for us that the yield we receive on a high-yield bond offers an appropriate level of compensation for the credit risks of investing. When yields are as low as this, that naturally becomes harder to say,” said Rhys Davies, a high yield portfolio manager at Invesco. “It’s quite simple — the lower the yield on the high yield market, the more carefully investors need to navigate the market.”

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Global stocks slip and bonds weaken after Fed signals tighter policy




Global stock markets dipped, European government bonds dropped and the dollar strengthened sharply after US central bank officials brought forward the anticipated timing of the Federal Reserve’s first post-pandemic interest rate rise.

The FTSE All-World index of developed and emerging market stocks, which hit a closing record on Monday, headed for its third session of losses on Thursday, falling 0.6 per cent.

The Federal Reserve said on Wednesday that most of its officials expected a rate rise in 2023, against earlier predictions of 2024, as the US economy recovered strongly from the pandemic and consumer price inflation hit an annual rate of 5 per cent in May.

Fed chair Jay Powell also said the world’s most influential central bank was “talking about talking about” reducing the Fed’s $120bn-a-month asset-buying programme that has boosted financial markets since March last year.

The announcement rattled the US Treasury market on Wednesday, as the prospect of higher interest rates on cash lowered expected returns from fixed interest securities such as bonds, with traders in Europe following those moves in the next session.

“It was a hawkish surprise,” said Keith Balmer, multi-asset portfolio manager at BMO Global Asset Management. “Markets now see the Fed as stepping in to control inflation earlier than expected,” he added, following previous comments from Powell that suggested price rises above the central bank’s long-term 2 per cent target would be temporary.

Line chart of FTSE All-World index  showing Global stocks dip from record high

The dollar index, which measures the greenback against trading partners’ currencies, jumped 0.7 per cent after gaining a similar amount on Wednesday as traders anticipated higher returns from holding the world’s reserve currency. The euro lost 0.5 per cent against the dollar to $1.193.

The yield on the benchmark 10-year Treasury note, which jumped 0.09 per cent on Wednesday evening to 1.58 per cent following the decision from the US central bank, moderated slightly in European trading hours to 1.558 per cent.

European bond yields, which move inversely to prices, raced higher as traders bet on other central banks following the Fed to rein in their crisis-era stimulus spending. The UK’s 10-year gilt yield rose 0.09 percentage points to 0.828 per cent. Germany’s equivalent Bund yield added 0.04 percentage points to minus 0.164 per cent.

Stock markets were less affected by the rate increase forecast as investors focused on the strength of the post-pandemic economic recovery and bought up shares in businesses expected to benefit from higher borrowing costs.

The Stoxx Europe 600 index, which rallied to an all-time high on Wednesday, fell 0.3 per cent on Thursday. Shares in European banks, which benefit from higher interest rates that enable lenders to make wider profit margins, gained 1.2 per cent.

The next US rate rise “will be happening at a time when the [global] economy is able to stand on its feet”, said Zehrid Osmani, manager of Martin Currie’s global portfolio trust.

Futures markets signalled the S&P 500 index would slip just 0.2 per cent at the New York opening bell after declining 0.5 per cent on Wednesday, while the top 100 stocks on the technology-focused Nasdaq Composite would lose 0.3 per cent.

Elsewhere in markets, the Norwegian krona rose 0.1 per cent against the euro to €0.984 despite the Norges Bank saying it was likely to raise interest rates in September. Some traders had expected an increase on Thursday.

Brent crude, the international oil benchmark, rose 0.1 per cent to $74.48 a barrel.

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Hawkish Federal Reserve forecasts jolt Treasury market




US equities slid and Treasury yields surged after policymakers at the Federal Reserve signalled that they expected to lift interest rates in 2023, a year earlier than previously thought.

The benchmark S&P 500 fell 0.6 per cent, led by a decline in the shares of technology companies including Oracle, Microsoft and Facebook. The Nasdaq Composite was also down 0.6 per cent.

The equity market decline accompanied a sell-off in the $21tn Treasury market, where the yield on the benchmark 10-year note rose 0.06 per cent to 1.56 per cent.

Among shorter-dated government bonds most sensitive to interest rate policy, there were even larger moves. The yield on the five-year note climbed 0.09 percentage points to 0.88 per cent, while the yield on the two-year note briefly hit its highest level in a year at 0.19 per cent.

“Just as the market was getting comfortable with a patient Fed and inflation considerably above target, the dot plot has shifted,” said Seema Shah, the chief strategist of Principal Global Investors, referring to the graph showing Fed officials’ interest rate predictions.

“Now it will be up to [Fed chair Jay] Powell and other Fed speakers to once again reassure markets that tightening in 2023 doesn’t need to be disruptive.”

The equity market rally over the past year has been in part predicated on rock-bottom interest rates, which the Fed has anchored near zero since the crisis began in March last year.

While policymakers at the US central bank showed that they could raise rates sooner than previously thought, they did not yet signal changes to the Fed’s $120bn-a-month asset buying programme, which investors are starting to expect will be tapered soon.

But markets have worried that signs of higher inflation, which Fed policymakers acknowledged in their economic projections published on Wednesday, could force the central bank’s hand.

“Given that the only takeaways from the Fed update involved higher rates, it follows intuitively that Treasuries are trading lower,” said Ian Lyngen, the head US interest rate strategist at BMO Capital Markets.

Ian Shepherdson, the chief economist at Pantheon Macroeconomics, added that the forecast for higher rates in 2023 meant that members of the Fed’s policy-setting committee “now are ready to talk tapering, so chair Powell is not going to be able to repeat his March/April stonewalling . . . We expect him just to acknowledge that the discussion is under way, but that a firm decision is a way off.”

The US dollar index climbed 0.4 per cent along with the uptick in Treasury yields. The pound fell 0.4 per cent against the dollar, while the euro slipped 0.7 per cent to $1.20.

European stocks finished at new records before the release of the Fed decision. The Stoxx Europe closed up 0.2 per cent for another all-time peak, the region-wide benchmark’s ninth session of back-to-back rises.

Frankfurt’s Xetra Dax rose 0.1 per cent, while both the CAC 40 in Paris and London’s FTSE 100 climbed 0.2 per cent.

Additional reporting by Siddharth Venkataramakrishnan in London

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