In the last article from this series in June 2020, I spoke about the impending doom of rising interest rates. I mentioned how this would be precipitated by additional federal government stimulus legislation and the need for the U.S. Treasury to issue more debt to fund so much new federal spending. For once I was right. The yield curve did steepen back in June. Specifically, most of the steepening occurred primarily on the 20-year point due to the new treasury issuance with that same maturity, the rest of the curve was relatively unchanged from the 0-10-year points. As a quick refresher, since the yield curve represents expected future interest rates, it also indicates growth expectations for the general economy.
And now my friends, we have a much broader steepening of the yield curve, where it starts as early as the 2-year sector, and gradually the steepness (or slope) increases as you go all the way out again to the 20-year point of the curve. See the below snippet of the current treasury yield curve from March 8 and the yield curve at year end 2020 (in green). You can also tell this from the bar graph on the bottom of the chart, which represents the difference in rates on each maturity of the curve again from March 8, 2021 and Dec. 31, 2020. The differences (bars) get increasingly larger as you go from 3-year term, to 5-year, and so forth up to 20-year:
So what does this mean? Bond markets, in my opinion, are fundamentally great. They are global in nature (one must take into account cross-currency fluctuations) and usually reflect the macro state of an economy in a given country. To this end, bond traders have to incorporate basically everything: economic production, industry changes, central bank manipulation (forgive me – “intervention”), borrowing/lending preferences, credit risk, societal health (pandemics), and then make an aggregate judgement with all factors in mind that can change essentially any second, both because of new information and a capitulation that you just plain got it wrong.
In my opinion, I might say bond traders are some of the smartest people out there, but I would never want to insult reddit users who specialize in GameStop stock technicals. That’s tough stuff. Also, to be fair, I’m just a sales guy, so I have no place to say anything really. But here I am!
Back to what this all means. With all the factors mentioned above, the most important one today is societal health, and the next biggest is the fed. The two are intertwined and we will eventually address both. Spoiler alert: I love Jerome Powell.
Question 1 – Why does the steepening start on the 2-year point?
Remember bond traders are smart, and what do smart people do? They think socratically! So the answer to Question 1 is really the answer to another question: When should the U.S. be coming full speed ahead out of the pandemic? And you guessed it my friends, it’s about two years away, economically speaking. That does not mean you won’t go back to the office for two years. It means all the things the pandemic temporarily destroyed – restaurants, hotels, airlines, movie theatres, my life (effectively) – will take about two years until they’ve hopefully fully recovered. There may definitely be some permanent effects on the economy, but it’s probably too early to trade based on that, and permanent effects would more accurately be reflected in 30-year rates (think long-term growth rates), not 2-year rates.
The pandemic is obviously a horrible thing. Luckily, we now have vaccines, but it will take a while for the country to be either fully vaccinated or reach herd immunity. And even once we’ve done that, the adjustment back to some kind of normal life takes time in itself. Certain people will make permanent changes in consumption. Some won’t. The takeaway is it takes time, and in this case, the bond market thinks that time will be about two years.
Question 2 – Why does the steepening get larger as we move through time?
This is where the Fed comes in. Some of this explanation is more qualitative, but try to stay with me. Powell has been explicitly clear, both in congressional testimonies and interviews, that the Fed will overshoot inflation, and basically do whatever it takes to get the economy working at full throttle again. This point is not really up for debate. The Fed explicitly changed its policy framework to no longer pre-emptively raise interest rates to inhibit inflation from surpassing the usual 2% target. And when we say the economy running at full throttle, statistically speaking we mean higher GDP and lower unemployment. If both of these statistics improve as desired, real rates must go up. It is effectively as close to a cause and effect relationship as you can get in terms of macroeconomics. So when the most powerful man in the room tells you what his intention is, and that he would even accept an economy that temporarily overheats in order to meet such a goal, then (if you are smart) you will expect higher future interest rates, which is what the current yield curve implies, because, you know, bond traders are smart.
To summarize, increasing rates is indicative of how strong end growth is (expected) to be now that we have three viable vaccines, the pandemic should subside, and growth will also be turboed by the fuel of yet another trillion-dollar stimulus package that was signed into law on March 11. Much of this growth is already reflected in the economic data as well. The labor market has already added back more than half of the jobs lost in the beginning of the pandemic.
The velocity and magnitude of the change in rates was massive, 10-year rates are up 75 basis points in a matter of months. Risk assets have most definitely taken notice and most commentary today focuses on higher rates causing the recent downtick in stocks. In the November market update regarding the election, I discussed how the tradeoff between tech and cyclical sectors will prolong in 2021. Lets see how that played out so far by comparing a normalized chart of the Dow (cyclicals sector, ETF DIA ) with the S&P 500 (beta, SPY) and the Nasdaq (tech sector, ETF QQQ) from December of last year to March 10, 2021. Please note, this is a normalized chart, which means it shows the relative returns thus far, not absolute levels:
Forgive me if the chart is confusing. It may appear that each sector has traded in the same direction, but try to look a bit closer. Tech initially came out the gate hard in January and cyclicals lagged. Now more recently, tech has undergone a +10% correction, and for the year the Dow has the highest return of all three thus far. Beta is right where it should be, in the middle (stop trying to stock pick you clowns, slow and steady wins the race). Also take note, all of these markets were crushed when Powell said, in more words than these, that he was not concerned with the recent rise in rates. Jerome hurt many stock traders feelings (and margin accounts) with this stance. The market has become increasingly reliant on the Fed for returns, which is structurally apocalyptic (forgive my seriousness). But thank god for a guy like Jerome. He stepped in massively when the economy needed it last spring, but only because the economy needed it. Now that the source factor is seemingly addressed (the pandemic via vaccines), it is time for him to gradually take off those training wheels and let the market trade on fundamentals again. In short, Powell was unquestionably right in his choice of words when asked about rising rates. He noticed it, but doesn’t necessarily think the Fed has to intervene. It’s normal for rates to go up when the economy can get up and running again.
Question 3 – What’s next?
I think cyclicals might continue to outperform amongst all 3 benchmarks aforementioned above. I also think that rates will continue to rise, with the 10yr probably increasing another 50bps by year end. With the stock market so concerned about rising interest rates though, and rates likely continuing to rise, the recent volatility we’ve seen in equities will likely persist. Fed based traders will sell due to nonaction by the fed as rates go up and fundamentals-based investors will buy the dip, as I expect company earnings to beat estimates based on pent up demand, general reopening, and again the turbo of another stimulus. The SPX will likely eclipse 4000 by year end and the 10yr yield at about 2.00%. Instead of trying to “time” each sector, it will probably be easier to just buy puts or calls with 2 month maturities on each ETF whenever their relative delta seems too large. It should be a fun (volatile) year.
But let’s be honest guys and gals, I don’t really know. I told you, I’m just a sales guy!
Photo credit: https://twitter.com/adam_tooze/status/1248600367979474944/photo/4