“Taper” is certainly the buzzword of the month for May, and the associated rise in yields spanned a full 62 basis points. Though the 165K increase in April Payrolls reported on May 3 was an upside surprise that kicked off the month, the catalyst of the historic move was more so three words Bernanke uttered while speaking on Capitol Hill. A Senator asked if the Fed would begin tapering as soon as Labor Day, and Bernanke answered: “I don’t know.”
The selloff in bonds is overdone. In particular, over the coming months I expect yields will collapse, towards 1%.
There is a reason yields are not there now. The fundamentals and long-term economics suggest that eventually the Fed will engineer inflation, eventually financial repression will end, eventually there will be a painful Fed exit, and the process of getting to eventually will involve an overshoot of rising bond yields. However, for present purposes, the “eventual” is almost entirely irrelevant, as the road to eventually is paved by current economic conditions, market technicals, and monetary policy dynamics. The route to higher rates will be circuitous.
The problem is that as inflation falls further below its target, and the economy continues to slow, Bernanke, and his presumed successor Yellen, will engineer dramatically lower 10-Year yields, putting the Fed balance sheet, and tapering concerns, on a distant back burner.
We have been living in a “New Normal” world: 1) It has been hard to achieve a high growth surge that normally follows a slow-down; 2) bucket loads of fiscal and monetary stimulus have left the globe even more levered than in 2007; and 3) there is now a risk of a hangover, meaning that current slow growth could descend into deflation and an implosion of asset values. We may find ourselves in second financial crisis, involving sovereigns and currencies, worse than the first involving real estate and banks.
Though post-2008 the plumbing problems have been patched, we have neither launched into a meaningful post crisis growth rebound, nor built up meaningful capital and net worth. Capital building, in a narrow sector like U.S. homebuilders, in bailed-out firms like AIG, FNMA, and General Motors or in the banking system more generally, has occurred simultaneous with increases in the public debt, and Central Bank balance sheet in the U.S., Europe, Japan, and elsewhere, each of unprecedented proportion. Meanwhile central bank capital, the net worth that assures that a central bank’s assets exceed its liability to currency holders and depositors, cannot sustain any meaningful losses on their asset side.
Turning to the household, gains through 2013 have been very concentrated. Even though pre-2008 market index peaks have been breached, average household net worth, adjusted for inflation is languishing (see graph). Researchers at the St Louis Fed put it this way: “Considering the uneven recovery of wealth across households, a conclusion that the financial damage of the crisis and recession largely has been repaired is not justified.”
Nevertheless the market has focused on the Fed’s “taper” musing. In particular, the recent economic data suggest that growth is muted, or stalling rather than rebounding. Therefore, while the Fed should worry about the dynamics of an exit, as a sharp rise in yields would crash the economy and markets, the current conditions point to additional accommodation being the outcome of upcoming meetings. “Pick your poison,” sadly, is the dilemma Bernanke faces, and he’ll pick more stimulus.
Put another way, something other than economic conditions has driven the backup in yields. This is highlighted in the graph below that both shows the spike in yields as a yellow line, and a shaded red/green areas that consolidate dozens of monthly economic reports.
What the figure shows is that U.S. economic statistics, weighted by how much they impact markets historically, have been missing consensus estimates pretty solidly on the low side since peaking in March, while bond yields have disengaged from these misses, and have shot straight up!
The global macroeconomic picture is worse.
In China, the stock market languishes just barely above its 2008 nadir, and has been in a downward trending channel since a post crisis peak realized in 2009! Though the new leadership enjoyed a two-month honey moon during December and January, that rally was short lived, and the three-year downward channel sustained. Meanwhile the raw material sectors have collapsed in recent months, as shown below in the six-month graph of Rio Tinto’s stock price.
The impact of China’s slowdown on raw material prices has been global as suggested by this recent Wall Street Journal headline: “Iron Ore Has Fallen 30% Since February”
A slowdown more broadly across EM also has been occurring in recent months, as reflected in the graph below. It combines a broad EM Economic Surprise Index, published by Citicorp, with a PriceStats graph produced by StateStreet and the MIT Team known for the “Billion Prices Project”.
Global investors are taking note, Barclays reports, as shareholders recorded large weekly net redemptions in both EM Bond Funds and EM Equity Funds going into May month end.
When we turn to Japan, another disconcerting dynamic is occurring, as the market is becoming impatient with Abenomics. I, for one, fear the BOJ is losing control of the JGB market, while the strengthening of the yen further thwarts their efforts. The repercussions of an Abenomics failure would be broad, but investors manifest their current fears in the price action of the Nikkei. On May 23 the Nikkei declined 1,200 point (-7%), and this was followed by further declines in four out of the five sessions going into month-end. Aside from the local implications, observers worldwide have to wait, as a true failure of Abenomics would be an indictment of activist government policies more generally.
Metrics of Eurozone economics are weakening as well, with price indices disinflating, Eurozone unemployment sadly setting a new record of 12.2% and no end to misery in sight. The political implication is an orderly dissolution of the single currency area. All politics are local, and in both the periphery and core, local populations favor local interests. All would see this as better alternative than social mayhem, that is hinted at by the disproportion pain inflicted on youth through unemployment.
It is with this backdrop that in the coming meeting the FOMC will be deliberating policy trajectory. I, like everyone else, understand that an architecture is in place for a taper. However, I’m also aware that policy will be dependent on economy. I expect the economy to remain weak, or get weaker, and the Fed to remain accommodative or increase accommodation.
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