With inflation agitating and high-yield indices at all-time low yields and nearly all-time tight option-adjusted spreads, do falling long-dated government yields make sense? Are the two markets sending the same signals to investors, or are they marching to the beats of different drummers?
The answer is not straightforward, especially as we emerge from the pandemic while a new coronavirus variant courses around the globe.
Though it is never easy to divine the message behind market moves, it has been especially hard since the Federal Reserve's June 15-16 meeting, when 10-year and 30-year Treasury yields each began a roughly 30-basis-point decline from then through July 21.
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The financial press and market commentators have weighed in with theories explaining the Treasury yield decline. Among them, in no particular order:
* The economic recovery has peaked, so equity markets have begun declining (small caps most noticeably) and money has started coming out of equities and into Treasurys.
* Treasurys are warning that the delta variant of COVID-19 will do more economic damage than people currently expect.
* Markets are reacting to an excess of liquidity — money has to go somewhere.
* The Treasury yield declines were caused by market technicals unrelated in any way to fundamentals.
Except for attributing the move to technical factors, none of these theories jibe with the strength exhibited by most equities and high yield. If the third theory was correct, that money had to go somewhere, that somewhere would be equities and high yield (as well as Treasurys), and those markets would be even higher than their current lofty levels.
Notably, one reason rarely mentioned is that Treasurys are confirming the Fed's view that the current inflation spike is transitory and that the economy will hum along with decent growth and — eventually — low inflation. More on this later.
The theory of everything
Peter Cecchini, director of research and head of macro strategy at money manager Axonic Capital, has an explanation for the Treasury yield decline that might connect the dots. Cecchini believes that the Federal Reserve is in control of the long end of the Treasury curve via quantitative easing, and therefore traditional market forces are not as important to yield moves at the long end as they once were.
At the same time, he believes that corporate debt markets and equities are so well bid because of fiscal stimulus measures. The new capital injected into the economy from multiple stimulus actions since COVID-19 struck — including the CARES Act, the American Rescue plan, and now possibly infrastructure spending — are finding their way into, and supporting, every risk asset class.
But this apparent market strength, he warns, "is masking fragility in corporate earnings." Cecchini believes that the risk asset rally will not last.
Cecchini notes that the Treasury curve inverted in 2019, a classic recession warning. Before that, even with QE at its disposal, the Fed had allowed the 10-year to rise above 3% while shrinking its balance sheet. Eventually, potential economic damage was forestalled when the Fed switched gears and implemented aggressive rate cuts and balance sheet expansion following equities' late-2018 swoon (which itself was also possibly a recession warning). Then in 2020, the pandemic forced the economy into a deep dive.
Now that fiscal stimulus and Fed action has brought about a recovery, Cecchini expects the economy will soon resume its decline — unless the Fed strikes again. And with rates already so close to zero this time, he believes that the Fed's room to act is now limited.
Cecchini believes that an important factor driving high-yield bond yields lower is the Fed's purchase of corporate bonds during the depths of the pandemic. Though total purchases were relatively small, and the Fed has now been selling the bonds, he says the buying "amounted to something akin to an implicit guarantee for corporate credit."
To Cecchini, the clear message embodied in both the Fed's action and what he views as excessive fiscal stimulus is textbook moral hazard. That is, the Fed, by minimizing the negative consequences of risk, is reducing investors' need for caution.
Also sounding the moral hazard alarm is Dan Zwirn, CEO of Arena Investors LP. Zwirn believes that the Fed's actions are taking risk completely off the table for investors. Regardless of what message declining Treasurys may be sending, "the fixed income markets, particularly investment grade and high-yield, have now been taught that the Fed and other developed-country market monetary authorities, as well as their respective governments, will move heaven and earth to protect them from panics and whatever items cause them."
Scott Schachter, vice president and high-yield strategist at Barclays, also believes that the Fed's support for fixed-income markets helps explain the decline in Treasury yields, though he did not take his reply into the realm of moral hazard. He believes that high-yield's performance is reflecting "solid economic growth as a backdrop for the rest of this year into next year, and the high-yield market is priced accordingly."
Barclays' Schachter says an important factor contributing to high-yield's low yields and near-record tight OAS is that BB credits make up roughly 54% of the market, near last July's 55% all-time high percentage, citing the Bloomberg Barclays U.S. High Yield Index.
He explains that through the pandemic, a combination of defaults culling weaker companies from the index plus fallen angels injecting relatively high-quality/low-leverage names into the index has left HY indices with, on average, the highest quality companies in history. That, along with the economy's strength, is skewing yields lower and spreads tighter.
High yield spreads link
Martin Fridson, chief investment officer of Lehmann Livian Fridson Advisors LLC and a long-time LCD contributor, found a link between high-yield investors and the Treasury yield decline that might express the same concern for the economy noted by Cecchini — perhaps offering a counterpoint to the bullish economic viewpoint from Barclays' Schachter.
In a recent story addressing the Treasury decline, Fridson wrote that in the last 20 years, on a monthly basis, roughly two-thirds of the time when Treasury yields fall, high-yield spreads widen. While that is not a surprise to most high-yield investors, he further noted that in early July, the degree of widening varied by sector.
Specifically, Fridson said high-yield investors "displayed a preference for non-cyclicals during the period, supporting the view that the [longer-dated Treasury] interest rate drop signaled at least a deceleration in the U.S. economy's rebound from last year's business downturn." That is, declining Treasury yields are confirming that the economy's best growth period is behind it.
Also suggesting that the economy's growth may have peaked is Joe LaVorgna, managing director and chief economist for the Americas at Natixis. LaVorgna keeps his eye on Fed Funds futures, specifically the 5-year Overnight Index Swap. He says that "recently declining Fed Funds futures reveal that the markets do not believe strong growth is sustainable."
Meanwhile, LaVorgna believes that excessive liquidity in the economy has recently been driving yields down and equities up. He says the Fed cannot allow equity markets to fall too far because of the current record level of participation by households in stocks. "The Fed has put itself in a box," he says. If markets decline much, consumers might pull back, dragging the economy into recession. The Fed, he says, cannot let that happen.
Morgan Stanley's Guneet Dhingra, executive director and head of U.S. interest rate strategy, has a different perspective than Cecchini, Zwirn, Schachter and LaVorgna. He thinks that the long-dated Treasury rate decline can be largely explained by technicals unique to the U.S. government bond market. They are not, he believes, sending a signal to investors at all.
Dhingra says that until the Fed's June meeting, longer-dated Treasurys had been roughly rangebound, while a trade being implemented across his customer base was "steepeners" — generally investors going long short-dated Treasurys and shorting long paper.
After the June meeting, the dot plot indicated two Fed rate hikes in 2023, versus zero before the meeting. That drove Treasury investors to "flatten their curve," unwinding the steepeners by buying longer paper and driving down its yield.
"It's just positioning to a large extent," he says.
So … what about inflation?
Fed Chairman Jerome Powell has for some time been insisting that current inflationary data is "transitory." Natixis' LaVorgna says Fed Funds futures confirm Powell's stance, that the Fed's actions are leading to exactly that result. He notes that the futures reveal not only an impending reduction in the U.S. economy's strength but that "inflation is not sustainable either. It is transitory."
Exhibiting a dose of cynicism and much greater concern for prices, Axonic's Cecchini says, "The Fed can't say anything other than inflation is transitory, because if they did, that would change expectations. They have to say it's not going to last." Raising inflation expectations would itself drive inflation higher.
"But inflation is real," Cecchini emphasizes, noting that the Consumer Price Index registered a 5.4% gain over the last year ended June, while the Producer Price Index printed at 7.3% for that period.
Arena CEO Zwirn also believes that inflation is unlikely to be transitory, saying, "Per Larry Summers' recent comments, with which we agree, the implementation of across-the-board Keynesian fiscal overspending when the U.S. budget is strained due to massive already-existing excess commitments domestically and abroad is reminiscent of U.S. President Lyndon Johnson's overcommitting to the so-called Great Society while trying to maintain the massive spending associated with Vietnam."
Zwirn believes that Johnson's actions led directly to 70s economic malaise, which President Richard Nixon could not solve by leaving the gold standard and implementing wage and price controls, President Jimmy Carter did not solve either, and was only finally tamed by President Ronald Reagan and then-Fed Chairman Paul Volcker.
Zwirn expects the Fed's current messaging will eventually have to change from "inflation is transitory," to "we have inflation."
When that happens, Zwirn concludes, "we will see how difficult it is to get that genie back in the bottle."
Amended at 6:53 p.m. ET on July 23, 2021 to fix a typographical error.