Clear Eyes, Full Heart, Can't Lose: Shorting the Long Bond Edition
An unbalanced boat leaning to one side is referred to as “heeling”. This is where the long duration trade is at - due for mean reversion.
Brief Recap of How We Got Here:
For background reading, check out the following:
The moral of the story is the market was too lackadaisical on the prospect of higher interest rates throughout the summer, culminating in a significant rise in rates through September. As per usual, this move was overdone to the upside catching the market offsides and that pendulum has now swung back the other way.
Shorting Duration is A Bet Against Consensus:
The market has moved swiftly towards a stance of Fed cuts and lower rates on the back of the December Fed meeting, arguably misinterpreting the communications which are already being walked back. I suggest reading this piece by the wonderful Harley Bassman from March 2023. He lays out the below framework.
The spread between FFR (5.33%) and 2yr (4.38%) is -95 bps today
The spread between 10yr (4.05%) and 2yr (4.38%) is -33 bps today
So assuming a return to the historical norms Harley notes implies a 3.88% FFR (4.38% 2yr less 50 bps), or roughly five 25 bps FFR cuts. And let’s say that does happen, is that stimulative or restrictive? Said another way, if the Fed cuts 125 bps to a 3.75-4% target range, should the 10yr go higher or lower than its current 4.08%? Harley’s historical playbook in that case implies a 5.38% 10yr (FFR + 150 bps).
As evidence of that extended positioning, according to the most recent BofA Fund Manager Survey, only 2% expect higher rates and 18% expect higher yields in 2024. Investors are three standard deviations overweight bonds and long similar themes in healthcare/staples, while underweight commodities.
Meanwhile it appears we may be seeing inflecting economic trends to the upside. I suggest a read of this thread https://twitter.com/PauloMacro/status/1743367264961761737.
It’s also important to remember that rampant fiscal deficit spending supports the economy and puts a floor on inflation. This is a one way train, especially in an election year.
Here’s another visualization showing the historical range of interest rates (top) in the most recent regime of subdued inflation (bottom), while the red shade highlights the range of rates when inflation is higher. This says there’s quite a way to go for rates to the upside.
Another tailwind for interest rates will be the ongoing changes to the oil market via the de-dollarization of trade and slowing US production that all else equal reduce demand for US treasuries. This one is a bit longer term / structural but something to keep in mind.
Coming down the pipe we have the upcoming QRA from the Treasury set to be released on January 29th should not provide the same gleeful result for markets as last quarter’s. Long end rates are now ~100 bps lower and Yellen should be looking to take advantage of that by terming out some debt. This should be a headwind for USTs. https://twitter.com/qthomp/status/1719763320998080998
Following that, the BTFP which has ramped up to over $140B in outstanding loans is set to expire on March 12th, again another support beam for the US treasury market. I see very little odds that the Fed does not extend this - we all know by now that temporary relief measures become permanent facilities.
Then lastly to round things out, the RRP should decline to zero near the end of Q1 which has served as a key support system for the US treasury market and liquidity overall.
What Happens Next:
The draining of the RRP and expiration of BTFP in March are the most obvious hurdles on the horizon, but the catalysts that could ignite these discussions begin with the Treasury QRA on January 29th followed by the FOMC presser on January 31st where Powell will be walking back the market’s expectations. I highlighted the liquidity event risk surrounding these dates in my key themes for 2024. Both are key market features aiding the absorption of US treasury issuance and overall market liquidity. There was also a good thread on the topic outlined here.
So let’s say the economy avoids a recession and the above situation plays out. What would happen? I think it’s pretty obvious from past actions that the government would step in. The extension of the BTFP is an obvious first step that I would guess may even come sooner than March if it hasn’t already been communicated to banks behind the scenes. A true liquidity event would require additional support above that though given it’s already in place.
As part of my prediction in the 2024 key themes outlined above, I expect the Fed to choose to end its balance sheet reduction rather than lower short-term rates. Why? First and foremost it’d be consistent with their actions over the last two years where they’ve chosen to support the long end of the curve rather than the FFR. They’ve shown this on numerous occasions by leaning into covert yield curve control operations. In an environment where inflation is too high and above target, this is an optically much smoother way to support markets and liquidity than lowering short-term rates. It is also more effective because long-term interest rates have an outsized impact on financial conditions.
The risk to my liquidity event prediction above is that it is becoming more widely discussed and even now by the Fed themselves. Both in recent comments from Lorie Logan and the December meeting minutes.
“Participants observed that the continuing process of reducing the size of the Federal Reserve’s balance sheet was an important part of the Committee’s overall approach to achieving its macroeconomic objectives and that balance sheet runoff had so far proceeded smoothly. Several participants noted that, amid the ongoing balance sheet normalization, there had been a further decline over the intermeeting period in use of the ON RRP facility and that this reduced usage largely reflected portfolio shifts by money market mutual funds toward higher-yielding investments, including Treasury bills and private-market repo. Several participants remarked that the Committee’s balance sheet plans indicated that it would slow and then stop the decline in the size of the balance sheet when reserve balances are somewhat above the level judged consistent with ample reserves. These participants suggested that it would be appropriate for the Committee to begin to discuss the technical factors that would guide a decision to slow the pace of runoff well before such a decision was reached in order to provide appropriate advance notice to the public.”
So let’s play that situation out - let’s say the Fed ends its balance sheet runoff completely. The marginal impact is a reduction in US treasuries hitting the market which would alleviate upward pressure on long bond yields. All else equal this would be bearish for the US dollar and positive for gold, risk assets, commodities and inflation. If it were to create enough of a spike for inflation, this would then end up actually adding upside pressure on long bond yields.
My view is that the Fed is often late, rarely early, and that rising bond yields will create a problem in the markets which leads to their eventual actions on the above. The fact that it’s already being discussed however could lead one to believe they may get out in front. In that case a reduction in the balance sheet runoff in a tempered way could lead to less drastic effects in either direction. No liquidity event in March and no real spark to inflation thereafter. In this case however, I am still of the view that the 10yr yield is still too low given the risks to inflation skew to the upside. One could say that is even validated by the Fed’s need to step in preemptively.
The fact that long-term interest rates have fallen as dramatically as they have, loosening financial conditions, while short-term interest rates have maintained their stimulative >5% level, almost undoubtedly tells me there will be a inflationary impulse as a result. Where housing and capital markets were previously frozen at higher levels, that transaction activity can now be unleashed.
So what’s the end result? A much more normal yield curve via a higher long end because as shown above, even with a number of Fed rate cuts, the 10yr yield is still too low. And if the government decides to not allow the yield curve to normalize via continued yield curve control? Then you get a decimation of the dollar, real rates and a boom in gold and Bitcoin.
Do with this information what you’d like.