Bond Market’s ‘Game of Chicken’ With Fed Is Set for a Reckoning

National Review

Treasurys Tremble

In a Capital Note last week, I wrote about the debate over inflation (coming or not?). With the minor exception of a $1.9 trillion spending package now passed into law, not much has changed since then, other than the fact that there will be more days when markets focus on inflation risk. Friday was one of those days. The Financial Times (late morning, Friday): A “storm” swept through the US government bond market on Friday, sending a key measure of long-term borrowing costs to the highest level since last February. Treasuries dropped in overnight trading after a large sale of long-dated bond futures in Asia, according to people familiar with the matter. Yields on the benchmark 10-year note, a key marker across global asset markets, jumped to 1.63 per cent, having traded around 1.53 per cent the day before. Analysts said the scale of the move underscored how jittery the $21tn market had become against the backdrop of a more robust economic rebound. Treasuries are the biggest and deepest market in the world, something that typically insulates it from sharp rises and falls in prices. Treasuries have been under pressure since the start of the year, as investors anticipate higher inflation and growth in the coming months following another enormous injection of fiscal stimulus with the passage of the Biden administration’s latest package. It is hard to deny that some anxiety over inflation is called for. With rates as low (in absolute terms) as they are, and with government debt so high, it is not as if there is much margin for error for bondholders. Back in December, Jamie Dimon, the CEO of JPMorgan Chase, commented that he would not touch Treasurys at the rates that then prevailed “with a ten-foot pole.” While this was hyperbole (as CNBC pointed out, “a lending institution with $3.2 trillion in assets, JPMorgan has to continually purchase Treasurys and other low-yielding investments to earn a spread, a fact that Dimon acknowledged”), the point he was trying to make was a fair one. Since then, the yield on the ten-year has risen sharply in relative terms (when Dimon spoke, it was yielding around 0.9 percent, against 1.63 percent at the time of writing on Friday), but in absolute terms, meh. Let’s put it another (and wildly over-simplified, yet not) way. Would you lend money to Uncle Sam for ten years at that rate? Would you feel well rewarded for the risk that you were taking? The question, I think, answers itself. In an article for the FT earlier this week, Thushka Maharaj, global multi-asset strategist at, well, JPMorgan Asset Management, notes that, “after taking into account inflation, real 10-year yields remain deeply negative,” and observes how low nominal rates leave little room for maneuver: “As a result, the extent to which they can move lower and provide protection in times of stress is limited.” What is more: The policy mix is changing. Fiscal policy is being used more actively to stimulate growth and monetary policy is prioritising higher average inflation expectations. This implicitly imposes a floor for bond yields. In short, stronger economic growth sparked by unprecedented stimulus or the return of inflation, will eventually lead to a pullback in liquidity support from central banks. Investors today, perhaps, are preoccupied with the risk that the economic recovery is too sharp, rather than not sharp enough. That is a fear that is not well hedged by a large allocation to sovereign bonds. Indeed not, and that is even more the case in the euro zone where any recovery looks set to lag that in the U.S. by quite some while, not least thanks to the mess that the EU has made of COVID-19-vaccine procurement and rollout. Meanwhile, the European Central Bank’s interest-rate policy is forever mired in the contradictions of a monetary union that should never have been born, something at which we will again be taking another look before too long. In the meantime, those interested (and who are able to peer behind the Daily Telegraph’s paywall) should read Ambrose Evans-Pritchard’s latest article. Evans-Pritchard is not always the calmest columnist there is, but it is hard to push back against his argument that rising yields in the U.S. may well cause problems for the ECB (led by Christine Lagarde, a central bank president with no central-banking experience). Lagarde is being forced into a tricky balancing act. On the one hand, a number of the euro zone’s “northern” milch cows would have little objection to higher rates. On the other hand, at least one of the currency union’s southern laggards might find itself a touch squeezed if it had to pay them. Oh yes, as Evans-Pritchard points out, the ECB’s balance sheet has already ballooned to 71 percent of GDP — twice the levels of that of the U.S. Federal Reserve. Evans-Pritchard: Fear of a German and north European backlash is visibly constraining the ECB. It partly explains why the bank’s decision on Thursday to counter US bond market contagion with more QE pledges degenerated into incoherence, prompting a blizzard of criticism from analysts and veteran ECB-watchers. “The outcome of the governing council meeting does not, in our view, bring any meaningful clarity to what the ECB policy is, in theory or in practice,” said Citigroup. You can see the statement after the Governing Council meeting here. And here’s an account of the press conference that followed. Enjoy! Evans-Pritchard: Lagarde contradicted herself. She said the ECB is trying to control financial conditions (to ease stress) but is definitely not pursuing “yield curve control”. Citigroup said these two concepts are “substantially the same thing”, so what is she talking about? “It’s not QE, it’s not yield curve control, so what is it?” asked Ruben Segura-Cayuela and Evelyn Herrmann from Bank of America. “We now have more doubts about the ECB’s reaction function than we did before. Do they target prices? Do they target quantities? Both? None? The compromise today leaves us nowhere.” The ECB’s pledge did succeed in lowering bond yields for a few hours, but the effect has mostly dissipated. Bund yields are higher than they were before the announcement. Bank of America said the EU had inadvertently created a cliff-edge that will be tested by markets and could make matters worse: “We worry beyond the next few months. At a time when a long-term commitment is needed, the ECB has shortened the guidance to one quarter.” Pimco called it a “muddle-through compromise of a highly-divided governing council”. Axa’s Apolline Menut tried to be polite: “ECB will have to get lucky, as they are not targeting quantities and they are not targeting prices either.” What it reflects is intellectual chaos at a split institution that no longer knows what it is trying to do. All the while, the external threat builds. Yield contagion and imported monetary tightening from the US is only going to get worse this year. Looking at it from a purely selfish American perspective, perceptions of trouble in the euro zone might increase demand for Treasurys, as, among the safe havens, the U.S. is still seen as the healthiest horse in the glue factory, so there is that. This might come in handy, not least, possibly, in the very short term if a short-term break given to the banks last March is allowed to expire. The FT: Investors are also on edge about the potential for a regulatory change at the end of the month that may hamper Treasury market functioning, with Scott Thiel, chief fixed-income strategist at BlackRock calling it a “significant factor” contributing to the recent volatility. At the height of the coronavirus-induced financial ructions last year, US regulators introduced a temporary rule change that allowed banks to exclude Treasuries and cash reserves when calculating how much additional capital they need to hold. The aim, in part, was to encourage banks to step in more forcefully to stabilise whipsawing markets without worrying about balance sheet constraints. The exemption is set to expire at the end of the month, and analysts warn a failure to extend it could magnify the problems in the Treasury market, especially given the sheer size of the supply set to flood the market this year in order to fund the record-sized stimulus programmes passed to support the economic recovery. “If the rule is not extended, it is certainly possible, maybe even probable, that illiquidity returns to the Treasury market,” said Kelcie Gerson, an interest rate strategist at Morgan Stanley. The rule should be extended. Some say that this is an irrelevance (I don’t agree), but even risking a rerun of last March’s shambles in the Treasury market would be unwise at this point, even if it could give banker-bashers on the populist left (Hullo, Senator Warren!) a potentially useful talking point. Bloomberg’s Brian Chappatta details the issues involved in an excellent article here. The whole thing is well worth reading, but some key extracts: As a way to push banks to help the country get through the Covid-19 pandemic, regulators allowed them to temporarily exclude U.S. Treasuries and deposits at the Federal Reserve from the SLR denominator because they are the closest thing to risk-free assets. In addition to helping banks continue to take deposits and lend during the health crisis, it also served to ensure they would help backstop the unprecedented fiscal and monetary policy support that flooded the financial system with cash . . . The Fed has been unusually silent about the SLR’s fate ahead of its policy decision next week . . . Some background: First, it’s important to understand the mechanics behind the Fed’s bond-buying program. When it purchases Treasuries from a money manager, those securities become an asset on the central bank’s balance sheet. The seller will deposit the cash it received at a bank, which, left…