US 10 Year Yields
The chatter in markets in recent weeks has all been about rising yields, which has been the theme in all corners of the globe. For example, the US 10-year yield, which started the year below 1%, briefly touched 1.5% on 25th February. One could credibly argue that 1.5% for a ten-year return isn’t exactly munificent, that it is still 0.5% lower than pre-pandemic levels and that a 0.5% increase in long-term yields isn’t that big of a deal. However, with rates as low as they are and debt levels as high as they are, this is a massive move.
The first thing to note, is that this move is first and foremost a tightening scare, rather than an inflation scare, evidenced by the fact that 10-year real rates tightened from -106bp to -61bp in the last two weeks of February, accounting for virtually all the move higher in nominal yields. This is despite Chairman Powell reiterating on 23rd February that the Fed is nowhere near tightening.
Other Fed officials made the case that the rise in yields should be viewed as evidence of the potential for a post-pandemic economic recovery as vaccines begin to work their magic and that they were not concerned about the move.
Our take is somewhat different. The markets are doing what they do best; they are testing the resolve of the central banks to keep control of the yield curve. This in turn, shines a light on that uncomfortable truth that we all know deep down; the world simply cannot live with an interest rates structure determined by free markets. We can survive the closure of our economies for a year, but 3% for 10-year money? Not so much.
The enormous government deficits of 2020 will be followed by equally large if not larger deficits in 2021, especially in the US where the Democrats are thinking big in terms their economic agenda, as recovery spending gives way to stimulus spending. It is becoming increasingly clear that the global foreign and domestic private sectors simply do not have the balance sheets to absorb this level of Treasury issuance. What has been described as “the worst US Treasury auction in history” last week in an auction of 7-year paper, came hot on the heels of a run of sloppy auctions.
If the global/private sector is forced to buy all these bonds, it will simultaneously drain private sector demand out of the economy and force up rates, starting off a cascade of bankruptcies all the way up to the sovereign level. Or the Fed could just create the money out of thin air, buy all the bonds and everything will be hunky dory. Yield Curve Control (YCC) and Modern Monetary Theory (MMT) are already with us whether we care to admit it or not. At this juncture, there really is no alternative.
The Fed and Treasury working in concert can achieve anything it wants in this regard. However, it is not to say they will not use their wide-ranging powers to draw in other institutions, in pursuit of their objectives. For example, in the nadir of the coronavirus panic back in April 2020, the Federal Reserve “temporarily” changed the Supplementary Leverage Ratio (SLR) rules to make commercial banks’ Treasury holdings exempt from any charge against bank capital.
The implication? There is almost no limit to the number of Treasuries the banks can buy and make a positive carry, if the Fed sets the right combination of lending rates and regulations. The result? In 2020, US banks grew their Treasury holdings (lending to the Government) by 22.3% while their total assets increased by only 15.1%, meaning lending to the rest of the economy shrank.
This change to the SLR rules is due to expire on 31st March 2021. We strongly expect it to be extended indefinitely. If it is not, expect last week’s chaos in the bond market to be the hors d'oeuvres. In a speech on 4th March, Jerome Powell the Fed Chairman failed to calm the markets nerves by providing clarification on the SLR. US 10-year yields continued to rise and high growth stocks were sold aggressively.
In the immediate future while markets try to call the Fed’s bluff, this can make for choppy conditions. Once we have found out where the pain threshold is and the capitulation occurs, this is pretty good news for markets and economies. Lots more liquidity sloshing around (the current $80bn per month, is woefully inadequate) to keep equities supported, bond buying programs to keep the large corporates financed, and government handouts for the little guys. In addition, all that government deficit spending to repair broken societies will be working its way through the real economy. What is not to love?
The answer is that once you wave goodbye to the last vestiges of a market-based system for setting the most important price of all; the price of money and move to officially administered rates all along the yield curve, you can never go back without a monumental collapse of the economic system. This regime change will have very important implications for asset prices and societies that it is crucial for investors to understand.