It Is Inevitable
The market and the Fed have operated from an outdated playbook. And now, the 10yr Treasury yield melt-up is here.
Welcome to the first edition of The Macro Rant, a chart-heavy weekly global macro newsletter with a multi-asset flare offering clear and unfiltered implications for global markets.
The Quick Read
Markets and the Fed are viewing this macro cycle with an outdated playbook. Here we offer a conceptual framework. Policy is still far from the economic choke point. Healthier household balance sheets make it harder to get there.
SOFR in whites/red strip will need to be repriced to at least reflect higher for longer or a fed funds rate with a 6-handle. Markets should be prepared for 2024 cuts to be priced out entirely.
This should push 10yr Treasury yields much higher. Other macro forces like a secular shift in foreign appetite for Treasuries is likely to gain traction as funding sources shift to duration and away from T-Bills.
This can be particularly violent as asset managers have prematurely positioned for long duration for the missing recession. 5% or more in the 10yr Treasury note is likely to be a reality.
While equities can hold their own on a late cycle reboot, a bond yield back-up is likely to be real rate driven which will trigger episodic equity vol.
The USD should be on better footing as a result especially as signs point to the euro having cyclically topped.
Pick a landing will ya?
The most anticipated recession never came. And the market has been perpetually disappointed. The SVB blow-up was supposed to be the thing that bond market schaudenfraudes would have pointed to as the “break” that would happen if central banks kept tightening.
Instead, what we got was a late cycle reboot (see housing and consumer spending). Atlanta Fed’s GDP Now points to upside growth risks in Q3 tracking estimates. Recession remains M.I.A. This is not to say that a recession won’t come, but the GDP arithmetic for one is getting more difficult to make it a reality anytime soon.
This time is different
Turns out, it’s tough to have a recession with the labor market still solid and importantly, consumer spending still operating above its pre-COVID trend. One key facet of this cycle that I find has been consistently overlooked by the recession crowd is that cyclical setup of the household is very different than the past. The Great Recession in 2008 kicked off major deleveraging of household balance sheets that made the economy less interest rate sensitive. Throw in pandemic savings and strong wage gains, you have a US consumer - a major source of demand for the world - that won’t back down (FWIW, check out this note by Jan Groen on excess savings).
Are we there yet? (Nope)
In his last FOMC press conference, Powell stated that policy is sufficiently restrictive. That’s a tough square to circle when the real fed funds rate sits at about 100bps (after adjusting for core PCE inflation). Why? This is still 270bps lower than the average real fed funds rate observed at the start of NBER designated recessions (~370bps). It’s not that there is a magical number to make it sufficiently restrictive, but historically it has taken a lot more in real terms to get the economic choke rate.
This is not just a Fed problem, but across the G7 as well.
More conceptually, the Fed’s estimate of the longer-term equilibrium rate as shown in the FOMC dot-plot is 2.5%. This has been lowered over the years as the Fed incorporated secular stagnation from the Great Recession. Despite this, the FOMC’s own long-run estimate of nominal GDP growth (core PCE + real GDP) from the SEP clocks in around 4%. The gap between the two implies a major disconnect. Adjusting for this gap into a simple Taylor Rule model would point to a fed funds rate that registers a 6-handle.
This conceptual framework suggests that the Fed is still very much behind the curve. Interestingly enough, the way that the SOFR curve is priced suggests that the market has somewhat caught on, as the green strip tails off around 3.75-4.00%. Another way to think of this is that the SOFR curve is not priced for a hard landing, for it was, it should price in a long-run equilibrium rate that is closer to or below the Fed’s dot-plot estimate.
The Fed may have reservations in lifting rates significantly higher from current levels given tightening in lending standards (which have their own restrictive effects). It does mean that the risk of a restart of the tightening cycle is there. But if the Fed doesn’t go there (because it’s scared to trigger a hard landing), it means that SOFR will eventually have to price out easing for all of 2024 as the economy is still below that ‘choke’ rate. In turn, it means that pricing in the late whites and red strips (Z3 to M4 in particular) of the SOFR curve will eventually need to shift to reflect a higher for longer stance, and that should also feed into the 10yr.
Then there are the funding needs, which is now shifting to longer duration instead of being focused on T-Bills. There is a lot of technicality around this move and funding the budget deficit, but the key implication is that this supply dynamic adds another natural upward drift on bond yields (particularly real yields). That could be problematic for asset managers which have increased duration exposure in their portfolios for the missing recession. The result is likely to be a messy positioning squeeze.
Treasury auctions will receive greater scrutiny on a go-forward basis. Reduced foreign participation will be a big theme given extremely punitive FX-hedged yields for major investors like Japan (it’s more attractive to own JGBs without the FX risk). This alongside an aging demographic puts a premium for yen-denominated assets and why the BOJ had to and will relax yield curve control again.
Putting these all together means that a short duration bias is the path of least resistance. Surveys of economic activity have rebounded, and core PCE services inflation ex. shelter has moderated but will require softer wages to be less of a threat to the Fed making good on its inflation target (structurally, we are operating in a new higher inflation regime but I digress). That should ultimately require a higher fed funds rate. That puts the USD in a better light to reflect a shift in widening interest rate differential not just in nominal terms, but in real terms too. It won’t be long before the market is looking at 10y yields at 5% or above. That means that equity markets, while able to hold its own on a late cycle reboot, will be more inclined to experience episodic vol events as the bond yield back-up should be real yield driven.
Next time, I’ll spend more time explaining why king dollar is back. For now, beware the 200-day…Good luck.