FULL FLOW RELEVERAGING
Updated: Jun 6, 2020
Following the heightened volatility in March, there had been a relative calm in the levels of government bond Real Yields across the world as Central Banks stepped in to assure markets that they would ensure Government Bond supply would be met by adequate demand. The Fed and BOJ have promised “unlimited” Balance Sheet expansion, the ECB has offered huge support, increasing it yesterday by €650bn to €1.35trn, whilst the Bank of England, RBA and BOC, Riksbank all have QE support programs.
BOND SUPPLY AND THE SHAPE OF THE YIELD CURVE
As outlined in a post on the 20th March, stable real yields are crucial to ensure market stability, and to this end, Central Banks did their job very effectively. Equity has subsequently rallied, corporate bond spreads have tightened, and emerging market currencies have stabilised (all far more than I expected). Private sector savings are not going to have to fund the large Covid19 induced deficits.
Recently in my weekly updates I have started to flag a rising imbalance between the ballooning US government bond supply against a corresponding diminishing Fed demand, changing the sledge hammer logo to that of a mere hammer:
1. Weekly net government bond supply is very large, but the Fed is buying an ever reducing amount of US Treasuries. The table below shows the weekly increase in debt against the Fed’s weekly purchases of USTs. The difference between the two shows the US government’s weekly net cash requirement from either domestic private savings and/or foreign savings. The number is getting larger – these cash requirements are vast compared to pre-Covid19 amounts (data available upon request).
2. There is a huge growing duration mismatch which is impacting the yield curve. In March the supply was predominantly short maturity Bills whilst the Fed was buying longer dated US Treasuries. Now there is much longer dated bond issuance and hardly any Fed purchases, so the duration hitting the market is getting larger.
The left chart below shows the steepening of the Nominal 5s30s curve (Blue) since mid-March, which has been predominantly driven by a steepening of the Real Curve (Green). This is very similar to what was seen after the start of the GFC (right chart below).
In the meantime, inflation breakevens have started rising in line with the price of oil. This is very similar to what happened post GFC. If oil continues to rise on a post Covid19 recovery of demand, breakevens should continue to rise with a flattening of the breakeven curve – see price action in 2009 and 2010 in charts below and above.
THIS TIME IT IS SUBTLY DIFFERENT
The rise in longer dated real yields (left below) has been the driver of the steepening nominal yield curve. In my last update I suggested “..there is a justifiable steepening of the real yield….which is likely to continue as long as the Fed eases back on its purchases”. Whilst the curve steepening is similar to that after the GFC equity selloff, the driver of the curve move is very different. The steepening of the real curve in 2009 and 2010 was due to Real Yields declining (right below), whilst now its Real Yields rising.
The behaviour of the yield curve has historically been important as a signalling effect and for its ability to offer capital gains from the rolldown of fixed income investments. Recent curve movements show that the signalling effect has completely changed, as the driver of the curve has flipped to now be the long end of the curve, not the front end. This shows that the US and UK are potentially in a debt trap, with their curves behaving just like those of Japan and the Eurozone, where front end rates have to be anchored at zero to avoid ballooning debt servicing costs.
This rising real yield led steepening of the curve confirms that the curve behaviour flip is indeed in place and is warning of a brewing supply/demand issue for long dated debt. It suggests that the net new supply of bonds to the market plus the net change of private sector positioning plus Fed purchases is positive, i.e. there are more sellers than buyers. Either the supply is not being met by demand and/or there are net sellers of USTs in the market, both of which are a larger sum than what the Fed is buying. That is a recipe for higher yields.
And the accelerating higher yield momentum points to the imbalance getting larger. The weekly chart below shows the weekly 30yr UST Bond yield and the rising RSI. The recent Divergence between lower yields and rising momentum warned that buyers taking the yield lower were losing strength. This week’s ~30bp increase in yields looks like a capitulation, suggesting a target towards 2.04%, the medium term moving average. This move higher is also causing damage to the longer dated monthly chart (right). It is still early in the month, but should the month close with higher yields, then a Bullish Engulfing signal will have been formed, WITH a break of the 18 month RSI down trend, giving a potential target of 2.30%.
This change in sentiment suggests that if economic data continues to meet expectations and the Fed does not change its current pace of UST purchases, then the market will see further rising long end yields.
YIELDS AND FINANCIAL MARKETS
This is not just a US Treasury issue – the same is happening on the long end of the Bund, Gilt and JGB curves, with a corresponding Bear Steepening of the curves as their front end yields also remain anchored. There has been a corresponding move in other markets:
Bank stocks have performed very strongly. Many believe that a steeper yield curve helps bank profitability, which together with expectations that an economic recovery takes hold, give a good reason for the rally in Eur (left) and US (right) bank stocks. However, higher real yields will bring a tightening of monetary conditions, which is not great for indebted clients. Furthermore, the recent reduction in credit spreads means that NII will deteriorate.
FAAANM stocks have recently underperformed. The dividend yields of Apple and Microsoft are 1.02% and 1.11% respectively, 60/70bp BELOW 30yr US Treasuries. With such low yields, they, like the non-dividend paying FAAANMs (zero coupons), are like a store of value. If the 30yr risk free UST rate starts rising, then one could expect these stock values to adjust, especially as they already trade on extremely high book value multiples (eg Microsoft trades 25 times net equity). This week they had traded poorly with the upside being sold, just as the divergence signals suggested they might. Today’s close will be very interesting given the risk of a weekly bearish Hammer at the very highs.
The USD has sold off – the strength of the bearish momentum can be seen by the RSI of the Bloomberg Dollar Index, which at 23 is at a 2 year low. Leveraged DM currency trades have performed exceedingly well. For example, the rally in AUD, NZD, SEK, KRW, CAD have taken their RSI levels to 78, 76, 22, 36, 28 respectively! Whilst Gold has held its value in USD terms, it hasn’t when dominated in other currencies. But price momentum does not look good for future prospects of gold in USD - the recent high was formed with lower positive price momentum (a classic Divergence pattern).
WHERE THE EQUATION DOES NOT STACK UP
Whilst back in March, when everything was falling apart, I thought that the stabilisation of real yields would bring financial market stability, I am nevertheless surprised by the speed and magnitude of the rally in risk assets and leveraged and EM currencies. I did not expect it due in large part to the severity of the data, which was coming out worse than I expected, all in a context of a highly indebted economic environment with low reserves. At best, I thought Central Banks would only manage to counter a deleveraging trend.
But the selloff of the dollar and performance of credit and equity markets demonstrate a strong private sector releveraging after the February/March correction.
However, the terrible debt dynamics, which have deteriorated further due to Covid19, remain in place. Furthermore the new Real Yield and Yield Curve behaviour suggest that the risk rally cannot continue for all and sundry if long end real yields continue to rise as Central Banks don’t increase their balance sheets further.
If Bond Bears win the day, which momentum indicators suggest they will, and private sector investors don’t buy enough US government debt (or European, UK, Japanese etc) leading to higher yields, then risk assets will surely have to eventually reprice to consider the possibility of a more restrictive environment of financial conditions. This might not occur soon, but this after all is what 4Q18 was all about. Real yields started rising in 2018 as the Fed was tapering its purchases just as the budget deficit suddenly started ballooning. Eventually the rubber band snapped, and risk assets corrected, necessitating Fed intervention to reverse it tightening policy to become loose, despite good economic data.
This raises the question of when that might happen. Currently market rallies are strong. Correlations between different asset classes are high. Even though short term indicators might show overbought prices in the short term, they are also in their very nature indicating strong trends – weekly momentum indicators do not show overbought levels at all. In 2018 the change in momentum of FAAANM stocks and highly levered currencies gave good anticipatory signals of a wider adjustment. Until momentum in these changes markedly, it makes no sense to fight the rise in yields or gold sell off, let alone the rally in risk assets.