We had thought the inflation/yield story was a normal development and it was silly for traders to overreact. We were wrong. Yes, the story has been developing since last summer, when yields hit bottom, but apparently it came as a surprise that yields could become real, i.e., nominal exceeding the inflation rate for a genuine return. We are not there yet by any means, but a rise to levels we last saw a year ago after a crash to 0.380% is a mighty move in bond market terms.
See the 3-year chart, and also the WSJ version, which squashes the timeline on the x-axis to dramatize the rise. The mode of presentation makes the information more frightening. We disapprove.
As noted above, Fed chief Powell seemingly didn’t say anything new in Senate testimony yesterday, but somehow the market heard him differently. Powell said the rise in yields celebrates the recovery, but traders heard Powell saying the Fed has no intention of imposing Japanese-style curve control. Yields can go anywhere the market wants to take them without interference from the Fed. The probability of curve control was always less than 50% and probably less than 5%, but never mind. Traders heard “full steam ahead” and started imagining yields so high that the return could become “real.”
Fed-watcher Beckner, writing at Mace News, reports “He largely dismissed explosive growth in the money supply, and interpreted rising bond yields as basically a market vote of confidence in the economic outlook and Fed policies.” Powell will be “patient.”
“The Fed has a long way to go before it will be ready to slow asset purchases, which the Fed has previously indicated is a prerequisite for lifting off from the zero lower bound. While anticipating ‘an improved outlook for later this year,’ he said, ‘the economy is a long way from our employment and inflation goals, and it is likely to take some time for substantial further progress to be achieved.’
“Powell also suggested there will be a long lead time ahead of any tapering by vowing to ‘clearly communicate our assessment of progress toward our goals well in advance of any change in the pace of purchases.’ Referring to the Fed’s revised long-run strategy, Powell also reiterated, ‘we will not tighten monetary policy solely in response to a strong labor market.’”
We do well to heed Beckner, whose book on the Fed was among the most perspicuous and also readable of its day. Beckner goes on: Powell addressed whether inflation expectations become de-anchored and persistent as we saw in the ‘60s and ‘70s. “… we have no intention of repeating that” and “it’s not a problem for this time. ” Asked about double-digit growth in the M2 monetary aggregate, Powell suggested the linkage between money supply growth, output growth, and inflation has been discredited.
The “classic relationship between the monetary aggregates and the size of the economy just no longer holds.” Also, “There was perhaps once a strong connection between budget deficits and inflation,” he said, but “there hasn’t been lately .…”
The biggest response to Powell may have been the Swiss franc, where rates both nominal and real will diverge the most from the US. This makes the Swissie a funding currency for carry trades, something we haven’t seen outside of the emerging markets for many a moon.
Off on the side, the WSJ tries to make hay out of straw by noting that “stress” is appearing at the short end, where the spread between the two-year Treasury yield and the rate on excess reserves at banks (IOER) is tiny, only 0.015% yesterday. Since the Fed last cut rates in March, the spread has normally been 0.05%. “Traders said the shrinking of this spread reflects appetite for short-term debt as investors gobble up safe assets and park their cash. It also highlights a key tension point in financial markets: to what extent is Fed support for markets taking asset prices to unsustainable levels, and how vulnerable does that leave bond markets and other areas exposed to sudden reversals.”
Huh? What this means is that the giant US debt issuance plus Fed buying artificially holds down rates, “leaving Treasury markets vulnerable to a sharp reversal once inflation rears its head.”
Ah, and there’s the rub. We simply do not have inflation now and Powell says inflation will not become “persistent.” A JPMorgan analyst calls it “hyperstimulation” of both fiscal and monetary policy,” resulting in “all this cash sloshing around the system chasing assets like crypto, commodities and meme stocks.”
Well, yes, and what’s your problem? There is always a tail of fools. While they are busily chasing speculative stuff, the real economy is starting to recover. Let’s note that the money market and bond guys have a scaremongering minority, but the FX market is (seemingly) more sanely balanced; we do not yet have a rising dollar trend based on real yield or growth differentials. To be fair, sterling seems to be getting a boost from its own rise in yields, but it’s impossible to tease apart how much is Covid recovery and how much is the BoE.
Econ 101 Tidbit: Free market competition results in lower prices and state-regulated monopolies result in higher prices. This is supposedly a keystone of capitalism–”consumers are rational and will serve their own self-interest by choosing the competitor with the lowest prices. But it didn’t work in Texas. The WSJ, champion of free markets, has a front page story on how Texas’s “deregulated electricity market left millions in the dark last week. For two decades, its customers have paid more for electricity than state residents who are served by traditional utilities.” Texas also got rid of the classic state-regulated ‘incumbent” power utility, so consumers had only the private providers to choose from. Because of the blackout, customers are getting bills for over $10,000.
See the chart. “Those deregulated Texas residential consumers paid $28 billion more for their power since 2004 than they would have paid at the rates charged to the customers of the state’s traditional utilities, according to the Journal’s analysis of data from the federal Energy Information Administration.” And they got catastrophically less reliability because those cost-cutting private suppliers didn’t bother to winterize against the predicted and normal once-in-a-decade snowstorms.
The WSJ sneaks in a reference to Enron and points to politicians who backed deregulation and are now eating crow, but fails to mention something every Econ 101 class teaches–”price is not the only criterion in consumer choice. Quality counts, and a top quality factor is reliability. This is why people buy German household machines and Toyota cars, although the Lexus just got top spot for reliability.
This is an excerpt from “The Rockefeller Morning Briefing,” which is far larger (about 10 pages). The Briefing has been published every day for over 25 years and represents experienced analysis and insight. The report offers deep background and is not intended to guide FX trading. Rockefeller produces other reports (in spot and futures) for trading purposes.
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