In some ways it has been like two heavyweight sluggers battling it out over the course of an extended bout, exchanging one haymaker after another. With each monstrous blow, the receiver is staggered temporarily only to reform and then unleash one of his own. Back and forth, back and forth until such time a winner will be declared - and we all lose.
I hesitate to elevate the Fed and its rate-hiking regime to the status of a serious challenger, though it qualifies for any short run period. Offering alternative money rates, the only real program policymakers have, they can influence the real champion, the bond market’s behavior. Somewhat.
If you own or are thinking of buying a 2-year US Treasury note, you’ll pay closer attention than someone thinking, say, ten years to what money market rates are now and what they could be over those relatively short two years. Using its reverse repo and even to an extent interest on reserves (they’re all excess nowadays), officials more directly impact all kinds of money rates.
But where Alan Greenspan once believed (his “conundrum”) a direct line (series of one-year forwards) existed rigidly linking every maturity and yield from there on down to the long bond, history has proven time and time again it gets real murky really quick.
Somewhere around that 2-year spot.
The fight began straight away, too, going back to the very day when Chairman Jay Powell abruptly decided in late 2021 “inflation” wasn’t transitory any longer. Whether politics or bad economics (using even worse Economics), the bond market disagreed it was ever inflation (recognizing the supply shock just like 2010-11).
At first the contest featured more sparring than any true combat; the Fed increased its benchmarks as is its playbook to which bonds initially offered only token resistance. The curve very modestly inverted between the 2s10s spot from March 2022, though never much and only sporadically.
Things heated up last June though, again, it wasn’t yet a true heavyweight fight. The punches became more intense, the Fed upping its rate hikes to 75 bps while inversions spread and deepened.
The match finally got going in September and October when “something” happened which triggered the first big response from the champ. Beyond late October, the Fed kept punching but bonds (LT) weren’t budging; yields went sideways to lower even as the FOMC voted for higher.
They would respond, getting in a good one in February upon the release of the January payroll figures backed up by a rash of suddenly “hot” economic statistics. Policymakers fashion them into their strike: forward guidance declaring higher-for-longer.
This was a simple yet effective tactic, tying any economic data that wasn’t downright awful to a “resilient” economy requiring ever-higher interest rates from the Fed. And if any better-than-atrocious statistics were accompanied by any consumer price measure still better than 2%, the greater the punching power.
The hit landed squarely enough, forcing bonds back on their heels. Rates rose especially at the crucial 2-year spot and LT yields followed in somewhat stunned fashion.
It would not last long because within weeks bonds struck back with a massive swing of their own – the banking crisis. This immediately stunned officials into complete silence, even a pause in the rate hikes while at the same time market interest rates would plummet and completely ignore any further action from any central bank anywhere.
This is, in fact, the whole basis for the conflict: what are interest rates?
To bonds or anyone employing intuition and common sense, falling rates especially from a low start are never a good sign. History has conclusively shown them associated only with the worst circumstances, those when deflation and depression have been widely acknowledged: the US in the thirties or Japan in the nineties, aughts, teens, and almost certainly the twenties, too.
But to Economists a central bank must raise rates to fight inflation. Never mind how during genuinely inflationary periods interest rates always go up on their own without any assistance, policymakers far removed from real monetary competence have instead attempted to fill that void with a bastardization of the mechanics.
They believe that a fed funds target isn’t high or low on its own and instead should only be judged in relation to the so-called neutral rate. If the Fed’s benchmarks somehow, someway find themselves above neutral, this would be “restrictive” and allow officials the ability to slow the economy (reducing demand for credit) and theoretically tighten against inflation.
Of course, no one can say for sure what the neutral rate is at any given time which is why it always appears like the Fed is just making things up as it goes. If anyone had a solid idea let alone a calculation for it, they’d be able to say in advance just how high interest rates must go to surpass neutral.
What happens instead is literal guesswork combined with the worst fallacy in statistics, presuming causation from mere correlation. As stupid as it sounds, the Fed (or ECB) just blindly hikes until it gets the results it wants. When (if) it does, authorities further presume it must’ve been due to the policy. Should that result be consumer price rates at or below 2%, then until it happens policymakers will never be certain if rates are above neutral.
Bond market participants quite naturally scoff at these ridiculous notions more akin to stylized primitive rituals than actual science; resistance to them isn’t really difficult to fathom.
That resistance got taken up a notch or two last autumn in what wasn’t some random coincidence. While the media spun those events in September as something to do with the UK’s pension funds selling government gilts due to the Bank of England’s good work, anyone really paying attention to the monetary system breaking down immediately recognized what was going on.
That very small list included, believe it or not, at least one of the central banker class.
ECB’s Isabel Schnable recalled in early March, ironically just days before SVB would break, there had been something really wrong in collateral; not in London, rather all over Europe which was too easily spotted in Germany’s top-quality issues:
“…the ‘scarcity premium’ that market participants must pay to obtain these assets [government bonds] has often been considerable, both in the repo and the bond market…in times of heightened uncertainty, when the demand for safe and liquid assets rises sharply, market conditions tend to visibly deteriorate. Last year’s [September] surge in market volatility is a case in point…At times, around half of the repo volume backed by German collateral was trading more than 40 basis points below the general collateral rate.”
The jargon is dense and the concepts can be arcane, even so it really isn’t all that difficult to understand once you overcome those modest impediments. What Ms. Schnable was recounting was nothing other than a collateral run.
During one, no different from any other monetary run, demand for usable currency skyrockets, in this case the best quality collateral. And as demand surges, the price does likewise only when it comes to collateral used in various ways like repo or derivatives, price isn’t nearly as straightforward.
Increasingly scarce issues “trade special” which means that participants are willing to borrow (securities lending that isn’t actually lending, instead hypothecation) good collateral at increasingly unfavorable terms. They will lend cash and accept a growing penalty when doing so: the repo rate they’re lending at well below other market rates.
As collateral strains become particularly acute, more trade special and often deeply so as Schnable was describing. Collateral values compared to cash go up which is why you’d accept so much smaller of a return when lending cash than you would otherwise.
To put it bluntly, the global monetary events in September and October were, in fact, the initial stages of what then became the banking crisis. Realizing this, the bond market then uncorked its first major counterpunch against rate hikes because of the deflationary consequences which would eventually follow, those which included March (and beyond).
Deflation is always associated (in reality if not Economics theories) with higher demand for safe and liquid instruments like government bonds the Federal Reserve would desperately like to drive lower in price (yields higher). In the case of top-quality collateral like Treasuries and German bunds, demand for safe and liquid takes on an additional element beyond flight-to-safety.
This punch/point was only driven further home once SVB then Credit Suisse (global monetary crisis and extreme collateral run, not strictly US regional banks unable to secure themselves against deposit flight) failed in March. It landed with such great impact it stunned the rate-hikers (and others) into silence.
The fight did not end there, obviously. The Fed has been itching to get itself back up off the mat because consumer price numbers remain elevated, in particular core measures (which tell us nothing useful about the state of the economy or the labor market) which they believe indicate rates still not restrictive.
Officials did so this week with the release of the minutes from their last meeting in mid-June (the pause). They contained first an acknowledgement there will indeed be a recession and one which is almost certain to begin this year (assuming it hasn’t started already). However, the text also noted a majority of the committees’ members remain committed to further rate hikes anyway!
In other words, announcing ahead of time there will be rate hikes even in recession.
This throws off the timing for the widely anticipated Fed pivot. By stating officials won’t even consider anything like rate cuts unless there’s something worse than a “mild” recession, it will now take policymakers longer to realize their error, requiring an even worse and more widespread deterioration in the data they watch for it to happen. As a result, the pivot gets pushed a little further into the future which means the 2-year spot on the curve has to acknowledge the punch.
As 2-year yields have gone up, LT rates have backed up, too, a successful counterstrike for higher rates after having suffered the blow from the first stage of the banking crisis which saw them fall sharply.
It was not a knockout, though. Inversions remain and are as bad as ever, which shows resistance continues to be strong and for all the same reasons. The bond market is now biding time for its next opportunity to counter with what is looking to be one final fight-ending uppercut.
And we know where it will come from: collateral likely tied to CRE and CMBS.
The Fed had the upper hand initially but got bruised badly last September. The market took the initiative which only hardened the resolve of the neutral-rate guessers. But after they landed a successful punch in February, bonds came back with a whopper of SVB and Credit Suisse leaving Jay Powell to attempt what is no better than a rope-a-dope with this rate-hiking-in-recession tactic.
Even if he is successful, we all lose. Sure, he’ll claim he traded a mild recession for the end of inflation, but that was never what this fight was ever really for. At best, we get a modest contraction for consumer price pressures that were only ever going to be transitory. This is what the fight has been the whole time, not how it ends but what it even was.
It was never neutral.
