• GB Davis

5yr TIPS were a Great Telltale - 8/28/20

On November 17, 2018, in " Rate Hike Cycle End Near Absent Artificial Inflation," we commented, in part

"Cramer is on the tape blasting the Fed. We still see the +25bps in Dec (having never wavered there).  Last time we checked in, we pulled back on a March hike.   Our current view (ceteris paribus) is that the Dec hike is the last one of the hike cycle.  We believe that the Fed will go on pause in Mar.  We believe between Mar and June it will evaluate QT and may put that on hold (while POTUS slams the Fed).  The only outlier we see is inflation from Tariffs, which has been announced but not felt on main Street, yet.  For example, on 1/1/19 price increases previously announced go into effect.  It's possible with a strong USD, and relatively strong US GDP, and a healthy employment market, new evidence of wage pressures could deepen.  At the same time the US economy is able to wait out deep structural issues in EU (eg Italy), and other global weakness.  They will not be forced to cut for some time.  If they time a 12-24 month recession, floating on a relatively strong USD, then some future  cuts can coincide with Corporate maturities and Refis easily absorbed, at most weighing on valuation.  We pointed you to the announced UsT issuance of Tips of the 5yr duration.  2020-2024 could look relatively good for valuation levels (so keep a buy list for such time) (we will update this broad time range in due  course, in the interim read up on "scaling"  

Why did we do this (in part):  IF the Fed front-runs the curve (YC) knowing that they will have substantially increase UST issuance near the next recession (now front and center), and they issue TIPS (taking inflation risk for themselves) - this is a likely sign to the market of when and where a recession and deflationary forces will occur - that was our read then as we relayed and is 100% correct.  As such, that would make for an opportunity to buy assets on the decline.  Our timing was 100% correct: 2020-2024.  We did not think that asset prices would come back so quick; or not have a second decline.  Up until the recent weakness in the USD, it has been very strong - all good insights almost two years ago.


NOW - we will touch on (briefly) - Yield Curve Control (YCC).


FIRST:


On June 9, 2020, in "FOMC on TAP," we indicated, in part: 


"For tomorrow's FOMC - Citi seems to be the only IB we have read that believes Yield Curve Control (YCC) YCC will be discussed - we think it's too early to discuss YCC here.  The Fed's Alphabet Soup of programs continue to serve their respective functions at the same time, the REPO market continues to show signs of stabilizing and the Fed continues to wind down short-end QE (call it what you will, that's what I call it).  We believe the Fed will focus on what is working and where they are proactively and pragmatically helping while highlighting risks and 'seemingly' balanced inflation, with energy having fallen, and now stabilized, food having risen across the board (generalizing) and many other good and services in shorter demand, seeing price declines (deflation) - as such w/ high unemployment and slightly deflating prices - they will (of course) continue to remain accommodative.  YCC is unlikely to be addressed materially until the Yield Curve becomes problematic one direction or the other: either through inversion (in which case NIRP could drag the entire curve down, but we view as a last resort), or a steepening (such as we saw over the past few days up to today, but needing to be much more dramatic ) on the backs of increased Treasury Issuance (as is forthcoming).  JPow is doing just fine from our arm-chair economics view. "

On June 16, 2020, in "Stratagems," we indicated, in part:

"Fed Chair Powell delivers semi-annual policy report to Senate panel, Fed Vice Chair Clarida discusses economic and policy outlook, Mester, Rosengren discusses economic outlook,  Quarles – most market attention will on Friday’s headline that the “Fed’s path ahead is extraordinarily uncertain” as well as on possible comments regarding a shift to yield curve control policy.  BOLD CAPS FOR A REASON: WE SEE YIELD CURVE CONTROL (YCC) FORMALLY INTRODUCED IN SEPTEMBER.  We continue to see no NIRP in the US (would be the last possible of almost all possible tools for the Fed), and other market participants indicate NIRP for Sweden, but not for BoE or ECB on the medium-term horizon."

 On August 1, 2020, in "Cross-Currents," we indicated, in part:

"Nordea on UST Curve and we indicated, first by the way, that Yield Curve Control (YCC) will be announced at the September FOMC (note: a flat (hopefully not inverted) curve, and formal YCC allows the Fed to target renewed UST asset purchases (i.e. QE) to the belly of the curve 2-7yr, and in this case, out to 10yrs now given technical nuances in order to create term structure – that is the goal and a tenet of capitalism.  “Developments at the far end of the USD curve have turned technically interesting over the past weeks as substantial technical damage has been done for bond bears. The 10Y Treasury yield has broken to the downside technically and the curve has flattened markedly. Rates markets remain reactive to the macro environment (stalling high frequency data are behind the drop), while it is more debatable whether equities listen at all. We highlighted several reasons why flatteners looked “yummy” in early July, which has so far been a good call. We keep the call intact for the coming 4-6 weeks as i) the USD liquidity momentum remains poor, ii) activity is levelling off and iii) YCC steepener bets are already VERY consensus-like.”  (Nordea, 7/31)"

On August 22, 2020, in "Taking Stock and Talking Stock" we indicated, in part:

"Our view has been and is still that Yield Curve Control (YCC) will be announced at the September FOMC - but it may require a drawdown in the equity markets and UST bid / flattener to get there before the unveil this tool formally.  Most market participants read the Fed Minutes release this week and resolved that the Fed has put YCC on the shelf for the time being based on commentary there in."  

NOW, we reverse and do not believe that the Fed will announce YCC in September.  Why? There isn't a pressing need - the curve has Term Structure and is steepening and has not run away yet - but this could change, and should it change, we see YCC at either the next FOMC (most likely and proper proactive countercyclical policy) or the second FOMC from there (reactive policy) On Thursday at virtual Jackson Hole, Jerome Powell could have taken the Fed's Inflation target from 2.0% to 1.5% (more realistic, and closer to what it has run at).  He did not.  At present they are forecasting the front-end of the curve anchored by UST REPO shoring and ZIRP - to remain there for years (5?) - and with UST issuance set to increase, and the Fed to allow inflation to run modestly higher than target, with target being now unofficially still 2.0%, the UST curve is already steepening. What will cause the curve to flatten?  If there is a double dip recession then the curve will begin to flatten again - at which point stimulus comes front and center.  This is not to say that after Labor Day, it is not front-and-center to begin with - whether $500b, $1T or $1.5T it will impact the UST market and Yield Curve.  At the same time, a double dip from a resurgent COVID Wave II this winter is also a material risk.  IF either of these risks materialize and the bond market begins to be bid (safety, risk aversion) then the prospects of the introduction of YCC being officially announced will follow - until that time, however, we now believe this to be shelved.  We have no idea what Congress will do and we have no idea if there will be a significant COVID Wave II - but - we do know that the Fed is prepared no matter what happens - while we don't expect anything substantially supporting a risk-bid - we do expect proactive and timely policy that would counteract countercyclical forces, evidencing in a low and flat YC, including those which may very well be structural but ignored in such capacity for political reasons in the short-term. Right now, in credit, Moody's is calling for corporate spreads to tighten - and that's a way point for us. We will be back at you after the Market Close with our Sector Dashboard.


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