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The market for US Treasuries has gotten pretty ugly in the past week, with the 10-year yield rising to its highest levels since 2007.
Last week’s projections from the Federal Reserve convinced investors the US central bank really won’t be cutting rates or loosening policy any time soon. In the presser, Fed Chair Jay Powell said he “would not” call a soft landing his “baseline expectation” (though it’s “plausible”), and that growth “may be decided by factors that are outside our control.”
Since then, 10-year Treasury yields have done this:
That’s a screengrab of twenty years of historical data from FactSet, because some strategists have started to talk in troublingly historical terms.
One of the louder warnings comes from JPMorgan strategist and vol whisperer Marko Kolanovic. This one carries the alarming subhed of “interest rates — history doesn’t repeat, but it rhymes with 2008”.
He’s been pretty bearish this year, and is remaining that way (with his emphasis):
With the recent market decline, our year end price target of 4200 set at the end of last year was reached (market is currently ~1% above our target). While the S&P 500 is still up for the year, the gains are entirely from a handful (7-8) of mega cap tech stocks, inspired by the AI narrative, and defying the sharp rise in interest rates. Perhaps a better gauge of macro-fundamentals is the S&P 500 equal weighted or small capitalization indices that are flat for the year and are underperforming cash (Fed Funds). Why haven’t we changed our defensive stance, and what could come next? Despite the strong early-summer rally, our framework continues to point to challenging macro fundamentals and headwinds for risky assets. This reasoning is based on market valuations (fundamentals), investor positioning, and various macro and geopolitical considerations.
Over the past 6 months, the headwinds for risks in our framework are stronger, and tailwinds weaker, in our view . . .
The core risk for markets and the economy is tied to the interest rate shock of the past 18 months.
Figure 4 below shows interest rate change for Fed funds, mortgage rates (30y fixed), new car loans, and credit cards over the past 20 years. Figure 3 shows the current change relative to post 2008 (GFC) averages, as well as the ~2 year change from post-Covid lows. These consumer loan rates have increased by ~4 percentage points, which is roughly a 60-70% increase for these payments. Now we compare this increase to the increase that happened in 2007 leading into the GFC. Compared to the pre-GFC average (since 2002), consumer rates increased by about 1 percentage point, roughly a ~15% increase. So the current change in interest rates is about 5 times larger than the 2002-2008 increase. Of course, consumer balance sheets and leverage in real estate markets and the financial industry were higher going into 2008, but investors should carefully monitor the propagation of the interest rates shock across markets and different segments of the economy.
In the charts below, Kolanovic highlights the unusually speedy pace of rate increases, along with the rising cost of debt across the broader US economy:
Click here for a bigger version. (Warning: he does commit the chart/table crime of calculating the percentage change of an interest rate, but he includes percentage-point change as well.)
Strategists at Bank of America say that while long-dated Treasury yields could keep rising, the :
Post COVID = there is no alternative (TINA). Today = there are many alternatives (TAMA). USTs are an increasingly compelling alternative to risk assets, in our view.
We expect US rates to keep rising until negative feedback from (1) real economic slowdown (2) risk assets, or (3) enough cuts are priced out — which would also contain the sell-off. US rates have risen sharply due to: (1) resilient US data (2) daunting supply / demand backdrop (3) stretched UST positioning. All of this has led to 75bp of 2024 cuts instead of 150bp in July. The recent sell-off was catalysed by the Sept FOMC. Powell likely is not confident that rates are sufficiently restrictive; likely higher US rates till they bite. Our bottom line: the path of least resistance is higher rates and steeper curve.
And TS Lombard reminds us that all of this is happening as global central banks continue to shrink the size of their bond portfolios:
The impact of QT is hotly debated, but someone needs to buy that extra supply. The Fed board of governors has estimated that reducing the balance sheet by around US$2.5trn over several years would be roughly equivalent to a 50bp hike (the reduction thus far is around US$1trn). However, it also emphasised the “considerable uncertainty” of the mechanical link of that estimate. Another viewpoint is that QE is largely a signalling tool, ie, the ECB is using it now to extend the cycle. This is an internal debate we have had at TS Lombard. Regardless, the shift from QE to QT signifies a price-insensitive buyer being removed from the market and that debt needs to be bought by someone. So, who is buying all the debt? . . .
They find that “real money” investors, hedge funds and US households have stepped in, as seen in the chart below. This is of course a bit difficult to parse because hedge funds and households are (comically) in the same category:
TS Lombard strategists Skylar Montgomery Koning and Andrea Cicione continue:
The supply/demand balance has put upward pressure on yields. As we wrote during the summer’s bearish FI storm, US issuance contributed to the surge in yields as it surprised the market in two ways: the sheer size of the deficit and the amount of issuance that required; and the maturity profile of the debt being issued, with more coupons than expected as T-bill issuance reached the percentage share of issuance that TBAC has set as a limit. But that surprise has been digested and yields are now at attractive levels. By the same token, central banks’ balance sheets are still being drawn down, but the delta is no longer negative (ie, the 12m balance sheet change is negative but is not getting any more negative). There has been something of a relationship between Fed liquidity and yields YTD but pulling out the graph to a longer timeframe makes the case harder to argue.
Oh and along with all of that issuance, there’s a US government shutdown looming. It isn’t clear exactly how that will affect rates, though; past government shutdowns haven’t moved the needle much, but they largely happened in the ZIRP era, as strategists point out.
Before wrapping up, we should also mention that Kolanovic pulled a 2007 strategy note out of JPMorgan’s archives, and found some similarities. We will admit to feeling burnt out on historical comparisons, after the recent resurgence of disco fever in the financial industry.
But he published the thing in full and added emphasis to the parts he finds similar, so we will let readers judge for themselves:
“If economic performance in 2007 unfolds as our economists forecast, we think the market is only partway through what could prove to be a challenging period of transition. In our view, a change in the psychology surrounding the credit markets started in mid-2006 and will carry over later in 2007:
Phase 1: June-August 2006. The Fed institutes its last rate hike on June 30, 2006, lifting the fed funds rate to its current 5.25%, a move many thought was overkill. The Fed officially pauses at the August FOMC meeting and risky assets embark on a powerful rally that not only lasts through year-end but carries over into early 2007. However, the economy is slowing perceptibly in response to a cumulative 425bp of hiking over the preceding two years, demonstrated by the decline in GDP from 5.6% in 1Q06 to 2% in 3Q06. A market consensus forms around the view that a rapidly slowing economy and a sharp correction in residential housing valuations will force the Fed into a series of rate easings. With the benefit of some hindsight, we might also call this the “denial” phase.
Phase 2: December 2006-January 2007. The economy provides compelling evidence that it is more resilient than many had earlier believed. The strong December nonfarm payroll report opens sceptics’ eyes about the underlying strength of the economy, and the renewed momentum is confirmed as economic data over the balance of December 2006 and January 2007 show an economy shaking off the effects of higher interest rates and high commodity prices. Market participants give up the ghost on their hopes for easings, accept that the Fed has engineered a soft landing, and buy (literally) into the view that a Goldilocks economy is in the making. Economic growth is solid at around 3% and led by a reinvigorated consumer; the residential housing sector slowly stabilises; corporate earnings growth moderates but doesn’t collapse; and inflationary pressures ease off but do not dissipate. Risky assets trade at full valuations and remain in a narrow, low vol range. We’ll call this the “head fake” phase — everything feels too good to be true because it is. In case you didn’t notice, this is where we are right now.
Phase 3: June-October 2007. Inflationary pressures should prove persistent as the healthy pace of economic activity puts incremental pressure on labour markets and utilisation rates. Market participants now will begin facing the painful realisation that the Fed will likely be forced to raise interest rates to contain inflation. However, before any move to raise interest rates, the Fed will intensify its hawkish rhetoric in an effort to prepare the market. Some investors will take note and reduce risk while others call the Fed’s bluff, stubbornly clinging to the view that housing, the consumer, and high leverage in the system will be legitimate excuses for the Fed to hold off. Risk appetites subside, sentiment deteriorates, and valuations of risky assets correct. The Fed goes ahead and hikes anyway. At the risk of sounding smug, we will refer to this as the “We told you so” phase. If, as we project, growth fears continue to recede and inflation concerns steadily increase, we think it is only appropriate that risk takers should anticipate a phase of valuations instability occasioned by a Fed that is determined to keep inflationary pressure within its well articulated targets. Our best guess is that such a phase could emerge later this year, possibly during the third quarter.”
Support for and/or gripes about this 2007 comparison, as always, are welcome in the comments.