The Bond Market's Consistent Contrarian Stance Makes a Lot of Sense

The Bond Market's Consistent Contrarian Stance Makes a Lot of Sense
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For a brief moment, and in certain places, it looked like it was supposed to. Global markets had caved at the end of last year, the perfect maelstrom which finally moved central bankers out of their boom dreamland slumber. Federal Reserve Chairman Jerome Powell famously went from rate hike and strong economy in mid-December to a hard Fed “pause” by early January.

He wasn’t alone. Other central bank members around the globe either expressed the same sentiment or went further. A worldwide dovish regime sprang up to replace the more hawkish tone previously set while Economists were convinced of globally synchronized growth.

Important indications began to turn around. The main curves (UST yield curve and eurodollar futures) plunged until January 3. Copper traded less than $2.60 the same day, and then went the other way. Stocks, which had bottomed out Christmas Eve, began their seemingly relentless rebound.

By April 2019, both the Fed and ECB included within their published statements basically the same reference using different wording. Europe’s central bank had said, “Financial market developments, which were typically more forward looking, were more upbeat.” The FOMC communication noted improved financial conditions.

On April 18, however, another turn for the worse. Copper the day before had nearly touched $3.00 (intraday) for the first time since last summer. That would’ve been a big one, a very positive round number reflation signal in favor of the dovish turn. Instead, as of this writing, the price is back under $2.65 and still falling.

The same day Dr. Copper briefly flirted with its psychological milestone, the benchmark 10-year UST did something similar. Also on April 17, the yield came back up to just about 2.60% after having gone as low as 2.37% toward the end of March. It’s now around 2.23%, sixteen basis points below federal funds (effective).

You don’t typically see long bond yields plunge below short maturity money rates. It’s not just abnormal, it is a profound signal.

Interestingly enough, it was federal funds of all things which suggested this was coming. Policymakers at the Fed may have been thinking improved financial conditions but all they really meant was stock prices. In their very own backyard, federal funds, there was brewing trouble.

On April 16, the day before the last small reflationary trend washed out, the effective federal funds rate (EFF) was 2.41%. This was 1 bps above IOER, an abnormal condition already that had arisen in late March (coincident to the last plunge in yields).

The interest rate paid on excess reserves, IOER, is supposed to function as something like a ceiling. Even Fed officials will concede that on its best days the program is a “soft” one. While that’s true,why it’s true is significant.

From late March until mid-April, EFF prevailed at 1 bps more than IOER. On April 17, though, suddenly EFF was 2 bps more. By Friday, April 20, the spread had gained another 2 bps for a total of four. Soft ceiling or not, something was really off here, something had changed.

It’s noteworthy for more than just the timing. As I’ve been writing for over a year now, federal funds is otherwise an irrelevant marketplace; the last vestiges of an era long gone. No one trades in this market any longer, aside from leftover liquidity provided by the FHLB’s (who are statutorily ineligible for interest on excess reserves).

So why was federal funds suddenly in such hot demand? The sparest of spare liquidity sprang back toward the center of the money universe. It was like any struggling household desperate for any means to keep paying the bills. You use that last credit card tucked far back at the rear of the drawer only for emergencies.

That’s pretty much all IOER does. It signals to us an emergency. After all, why would banks supposedly overflowing with capacity, as Jay Powell tells it, sit there and let EFF rise above that specific rate. Then again. Again. And then one more time.

By the start of May, the spread of EFF over IOER had grown to 6 bps. What that meant was any bank parking “excess reserves” at the Fed and receiving the IOER had the risk-free opportunity to pull them out and use them in federal funds. The profit was more than just 6 bps, too, since EFF is a weighted average (actual trades take place above and below the average, and with the average rising it meant more above than below).

If no one steps in when there is really no risk to doing so, what does that say about everything else? Copper, eurodollar futures, and bond yields since April 17 are your answer. Textbook deflationary symptoms. Liquidity risk is huge; no one can step in.

As such, commodities are sold while the safest, most liquid instruments are in high demand – no matter, as noted last week, the inarguably poor long run fundamentals of the issuer. It just doesn’t factor how the US government is technically insolvent a decade or less from now, what does is how the dreaded collateral call from BONY tomorrow is far, far more likely when federal funds behaves this way.  

This isn’t a new development, either. One year ago this week, on May 29, 2018, the world was rocked by what the FOMC would later call “strong worldwide demand for safe assets.” Bond yields everywhere were supposed to be rising consistent with globally synchronized growth and an inflationary breakout toward recovery at long last. Instead, a sharp period of acute demand which sent interest rates tumbling all over again.

While officials have spent the last year ignoring and dismissing May 29, its aftermath is visible everywhere, too. On just about every chart, that one specific day stands as the inflection point. Whereas there had been some mild if positive reflation beforehand, it all turned around right then. It’s been largely downhill ever since; with the speed we are traveling downhill picking up the further we go.

What happened on May 29? If you go back in the mainstream media, you’ll only see references to Italy. Some stuff about the proposed finance minister of the new populist government which isn’t popular in the mainstream media. None of it truly matters today because it had nothing to do with what happened then. There was no serious inquiry.

In general terms, May 29 was the very thing bond curves had been warning about all throughout 2016 and 2017. Nominally, rates had risen along with the Fed’s rate hikes. Not because the bond market agreed with them, but because in the universe of money alternatives there is (limited) power in the alternatives.

But long rates were not rising nearly as fast as the slowly moving short rates. The yield curve flattened dramatically as a result, Janet Yellen’s 2017 update to Alan Greenspan’s 2005 “conundrum.” That was the long end disagreeing with the basis for the short end hikes.

What it said was the financial firms who largely make up that part of the curve knew the chances of the global economy making it all the way to recovery and normalcy after a decade of malaise and depression were slim to none. It didn’t matter how many central bankers perfectly synchronized and choreographed the most glowingly positive statements, how many bond kings called for an end to the 30-year bond bull.

The reason? A May 29 was almost certainly going to happen long before the world’s economy could get anywhere close to their emotionally satisfying liftoff. The system was bound to break before then.

I wrote here in November 2017, at the very height of globally synchronized growth’s inflation hysteria:

“Yield curves are flattening, alright, only at the start of the process rather than at its end.  It’s this that has central banks, and the media, nearly apoplectic.  Central banker after central banker says things are working and getting better, and that because of this they will raise the short end of each curve. The bond market reply isn’t that central bankers are wrong about what they will do, it’s more so that markets don’t care one bit because they are wrong about why they will do it.

“In short, bonds are calling the inflation/growth bluff.  And why wouldn’t they?” 

Economists and policymakers the world over merely believe that monetary policy works. What they don’t tell you is how this is an assumption. A big one. The basis for it is even less compelling: econometric models rather than real world observation.

If 2008 hadn’t provided enough of a test, there was 2011 and then again in 2015-16. The monetary experiments of QE had produced a conclusive answer, alright, just not the one any central banker cares to admit. These people really have no idea what they are doing. They have no idea how the economy works, and even less idea about the monetary system (thus, federal funds as it is today).

In other words, a strong basis for skepticism. Back to November 2017:

“The yield curve is a perfect example.  To me, again, it’s telling the world there is everything still wrong in not just the economy but more so money (the interest rate fallacy that is actually being tested, successfully so far, by central banks “raising rates”). But in the regression analysis of Economics it doesn’t compute.  All that math says that when a central bank is raising rates it’s because monetary policy works, therefore the bond market that doesn’t respond in that fashion must be wrong.”

The yield curve of 2017 said to expect something like May 29, 2018. What happened on May 29, 2018, told us we were almost certainly going to be heading toward where we are now.

And once again the yield curve and bond markets are instructive. Today, the eurodollar futures curve is inverted by about 70 bps front to trough (the low point in the inverted curve’s surreal “smile”). If you were to take the futures price at that point literally, it says 3-month LIBOR is going to be about 1.80% around the Spring of 2021.

Currently, 3-month LIBOR is fixed at 2.52%.

But the market isn’t projecting exactly three rate cuts between today and then. This is, like the yield curve, all about probabilities and probability distribution. There are those in the marketplace who think things will go fine, and those who think things will get really, really bad.

Where all those perceptions meet is in the market price. If there are more people thinking bad than fine, the eurodollar contract price rises indicating more are expecting money rates overall to be lower in the future. Therefore, as the eurodollar prices have skyrocketed especially since April 17, more and more of this huge, deep market is agreeing on the downside – lower interest rates.

How many rate cuts does this mean? Again, a probability spectrum whose middle right now today rests at around three. This would propose a minimum of one to two as a best case, the upper bound, and a maximum getting closer and closer to a return of ZIRP. The more prices rise, and UST yields fall, the more that probability distribution re-centers itself in that way.

Everything else is interpretation – with the exception of why this is happening. We know why it is happening, and it has nothing whatsoever to do with trade wars or QT. The bond curves all said what was wrong long before either of those were anything. The flattened curves proposed a monetary system which was still malfunctioning even during the best of times (for these last ten years, anyway).

While central bankers saw globally synchronized growth and a breakout, the bond market, the meat of which are these financial institutions situated very, very close to the real economy and its global reserve currency arrangement, saw central bankers greedily fixated on their own parades and congratulatory media flattery. It was reminded just how these “authorities” are not serious people.

What would it say if, when the history of the next few years is written, Jay Powell is doing rate cuts, a lot of rate cuts in the very same calendar space he forecast and prepared for a final recovery? He is not a serious person.

And that gets us closer to the truth. When you realize Economists and central bankers (redundant) have no idea what’s really going on, then the bond market’s consistent contrarian stance really starts to make a whole lot of sense. These people were given every chance to show some real money muscle, and they responded with wordplay and asset swaps disguised as inflation expectations. A puppet show.

This is why following 2011 interest rates all over the world have been lower. Not in a straight line, every few years it looks like there might be a small chance of escape only to have the higher probability May 29-like event show up and demonstrate reality. Milton Friedman’s interest rate fallacy is being proved yet again right now before our very eyes.

The funny thing is, the biggest of ironies, this time it’s been federal funds right in the middle of it. The only reason anyone had paid any attention to the market was by the FOMC’s specific choice! Officials in 2013 and 2014 had studied moving monetary policy to a repo rate or an amalgam of far more relevant money factors.

They specifically chose to keep federal funds as their primary communication tool because, essentially, our central bankers were worried you and I were too unsophisticated and limited to really appreciate and understand a different number.

As it is turning out, federal funds may prove decisive in showing the world it was always the other way around, just as the curves had been pricing. Monetary officials obsess entirely about things like a communications tool that really doesn’t matter at the expense of monetary competence which, we are being reminded, truly does. 

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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