Tim Graf(TG): This is Street Signals, a weekly conversation about markets and macro, brought to you by State Street Global Markets, the markets and financing division of State Street. I'm your host, Tim Graf, European head of Macro Strategy.
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Hey, everyone. It's all about bonds this week on Street Signals. Ever since the chances of Donald Trump winning the US Presidential election began rising in early October, fixed income markets have come under significant pressure.
In part, this is surely down to the fact that Trump's policies looked more likely to maintain large deficits and potentially raise inflation expectations. But it's still a somewhat unusual move in that right around the same time, the Federal Reserve actually started an easing cycle lowering rates. But this looks like an easing cycle that might be very short, particularly given the more inflationary nature of the policies of the new administration. The Fed themselves acknowledged this at their December meeting.
It has made for big moves in bond markets ever since. So to help us sort it all out and make sense of what we're seeing, it's great to have Marvin Loh back on the podcast. Marv is a senior strategist on our team in Boston, and he spends much of his time looking at US Rate markets, Fed policy, and all of these questions of deficits and debt levels and what they mean for US treasury markets.
Marvin Loh (ML): Hello, Timothy.
TG: Hello, Marvin. How are you?
ML: Good. Where are you today? Is this your office?
TG: Yeah, this is our rental property. You good?
ML: I am good.
TG Okay. Well, Marv, to start with, I have some bad news. Until last week, the episode we did ahead of Jackson Hole in the summer had the most downloads of any episode done by a State Street employee. It kind of went viral in a sense, the way podcasts about Jackson Hole often do. But you have been eclipsed in the last week, Marv.
ML: Oh, no. Who's that?
TG: It's a guy. He's a little bit - he's maybe a level or two above us. A guy named Ron O'Hanley, the CEO. He took your crown so rightfully so.
ML: We'll try to take it back.
TG: Yep.
ML: And that might be a career risk. So we'll have to see.
TG: I tell you what, the pressure is on, but I won't tell him, of course, because now I regularly speak to him. Got him on speed dial.
ML: You're actually going to Davos this week, right? You're heading off too right after.
TG: That's true. Yep, yep. My bags are packed, got my skis all waxed, so ready to go. So no, the pressure is on a little bit, Marv, because you got to get your crown back. But I think we've picked the right topic. In fact, this is a topic that has come to me by request almost and just really looking at the way markets have been behaving since the start of the year, I think for very good reason, we're going to talk about the volatility we've seen in bond markets, direction of rates, what's driving rates and actually that's where I want to start. And let's forget about the actual direction. We'll talk a lot about that in a moment. So let's just talk about what drives yields full stop and then we'll talk about what's been driving them in recent weeks.
Can you just go through the very basics of what really drives say a 10-year US yield?
ML: Yeah, for sure. So obviously inflation is the most important driver for any fixed income product. So expectations around inflation, the path for inflation, and really your comfort with that path for inflation is encapsulated in the yield broadly, the way we look at it is a function of break evens, it's implied from the nominal and we take out that real yield, that TIPS yield, if you will, and you're left with what inflation expectations are.
There have been different episodes with regard to what the primary driver of yields are. Early on it was a repricing - and when I say early on, let's think about the surge in yields sometime around when the Fed started to cut rates - when we had the elections, we had a fairly significant adjustment in those real yields, if you will.
And that was in my mind a repricing of what the growth outlook for the US was. So we kind of went into that rate cutting cycle with a view that the post pandemic world was going to quickly get to a point where it looked like the pre pandemic world and the Fed ultimately, from a real yield perspective, didn't need to be as aggressive. All of a sudden they cut data starts to get stronger and we need to reprice what winds up being a more robust US economy than what the market expected. So I think that was kind of the first wave into higher yield.
And then we wound up getting data which wound up not only moving away from the Fed's targets, but ultimately looking as if it were going to be stickier and potentially structural. That wound up being a bit of a disruption which we really haven't focused on because the Fed was pretty much of the view that we were getting to 2 percent and we're going to get to 2 percent sometime in the middle of this year.
All of a sudden break even(s) start to rise. So those inflation expectations started to rise and that was a different wave. And then you've got kind of the wild card in all of these discussions, something that you and I have talked about, and that's the term premium, which is almost this residual kind of number. When you really can't figure out what to make of either your inflation expectations and, or comfort with the outlook for demand of treasuries, you get this residual number and it's encapsulated in real yields to a certain degree.
But based on various models we can dissect it. And all of a sudden this term premium, which had been negative for the better part of the last several years and actually if we kind of go back maybe 10 years ago when it started to drop into this negative area, not only became positive, but it started to surge. And that really wound up creating the biggest question marks with regard to the, to the rates market. And that's been the larger discussion going into the start of this year, that increase in term premiums, what it means and whether or not we've accurately priced the uncertainty associated with, with our forward expectations in the rates world.
TG: So let's take a step back and you've described term premium as a residual, as kind of the difference of two variables. But you're - well, Marv, you're an academic now as well, so you can't just say, oh, this is just X minus Y and that that's moving.
Can you give me a sort of broader description of what term premia is? And I don't mind the sort of academic definition of it because there is one to it. It is a very nebulous concept and I want to see if you can kind of bring that home to us and describe what it actually means.
ML: Yeah, it is nebulous. It's kind of in the same sphere as R star, one of those things that you really can't get comfortable with until it happens. You know, that's, that's one of the biggest question marks with regard to R star and term premium. It's always something that you can only observe once it's happened.
But the few models that are out there are somewhat based on looking at what a series of short term interest rate expectations are going out into, let's say the 10-year term premium, if you will, a series of these strip short term rates, bootstrapping them, looking at it from a nominal perspective, and then it's that residual, what amount of return does the investor need ultimately to take the duration risk, the excess compensation required to kind of lock in for that nominal, you know, in this instance, 10-year type of period.
TG: Okay, that was perfect. That I'll, I'll give you an A on that. Yeah, good.
ML: There might be students that hope I, I grade that way.
TG: You can use this as part of your sort of marketing material for your course.
ML: Excellent.
TG: I have one more question before we move on to what's been going on the last couple of weeks and especially this week with the inauguration of Trump and some of the movements around that and that you mentioned is the rise in long term yields with the onset of the Fed easing cycle in September. And this has been pointed out. Well, it's very unusual. The Fed cuts rates. You usually expect yields to go down, even long end yields. Even though the Fed is, is moving short term interest rates, you still expect long term interest rates to also move lower.
But that, as you pointed out, did not happen and you gave the reasons why, because it was better growth data. And maybe the need for the cycle itself needn't be so deep in terms of the rate cuts.
But do you think of that as a worrying factor that rates went up when the Fed cut rates?
ML: Maybe not necessarily from the traditional reasons that folks would expect. Certainly higher yields are something that one would not expect once we started the rate cutting cycle. What we've had kind of during that period is a fairly aggressive rethink when it comes from the Fed's perspective, but also to a certain degree the market's perspective in terms of what neutral is and how shallow this cutting cycle might be relative to what they had expected. That should ultimately be something that we can mathematically assume, put probabilities around and wind up in an environment where we've got at least a better explanation around where long yield should be.
I think that this entire cycle, and I guess it's really more the normalization cycle, although we could probably bring the tightening cycle into it in that we had a lot of surprises on the tightening side of things. Also remember, really thinking about 50 basis points was unheard of. And then all of a sudden we wind up with 75 basis point hikes, if you will. That really does show a Fed that didn't have a grasp of, of what the economy look like.
Now we're going into this downslope, this normalization if you will, starting at 50 basis points, really start really hoping to frame it from the perspective of, you know, mission accomplished. We can go out with big guns because we feel comfortable that we're going to, that we can get to what we think neutral is in a fairly aggressive period. Why wait around with it? All of a sudden they have to rethink that. Within a three month period you've got a market that's really questioning whether or not that sustainability in the Fed's view makes sense. They're reacting to data at a point where they should really have a much better view of what the end goal was. So, when you're really worried about Fed credibility from that perspective, you're taking it out on the duration side of the discussion again.
Uncertainty around holding this bond for this extended period of time at this fixed rate is something that needed additional compensation based on the fact that really either the economy is in a very, very different place and or you have a central bank that's much too reactionary. And you know what? I want additional compensation because sure enough there might be some things that come out of the economy that the Fed doesn't really expect. Now how you encapsulate that to a certain degree from interest rate risk perspective is the concept that the Fed might need to hike rates.
So a re-acceleration of the economy I think has been one of the bigger aspects of this bear steepening, particularly since the December FOMC when we saw a fairly aggressive sell off at the long end, particularly relative to what we were seeing on the policy rate side of things.
TG: Yeah. So let's put this into context for people listening in in the history, the recent history of movements in longer dated yields with the Fed beginning its easing cycle with rates in a range between the policy rate in a range between five and a quarter and five and a half percent. The very, very short rate. When that was first cut in September, US 10-year yields were around, let's call it 3.70 percent. The Fed has cut rates by 1 percent down to four and a quarter to 4.5 percent. Short rates have gone down by that much. But the long end yields that we've been talking about went from 3.70 percent as I mentioned before, to a peak of 4.8 percent in a three-plus month span.
So a very, very large move higher in long end yields. That's the context we're talking about now. Just in the last week or two, we've seen a very partial reversal of these effects. And this, I think, gets to the point of why are things now reversing? Why are we getting a rally in yields particularly?
We're recording this the day after the inauguration for Trump's second term. Particularly given on the margin, his policies all look quite inflationary. They may not all see the light of day, of course, but on the margin things look as though rates maybe should be higher. And yet you've seen a pretty strong rally in the bond market over the last week. Can we talk about what's changing there and what are those factors that you mentioned before are driving that?
ML: Yeah, so I don't think that a big part of the rally that we've seen, the rally in bonds towards lower yields is much to do with Trump at this point. I think what we've seen is some data that, again, it's amazing that we're trading as aggressively on single data points, but you're seeing data particularly on the inflation side of things, which shows that maybe the most extreme concerns about re-acceleration in the economy is either a bumpy road and or is premature from the view that we're going to have to hike rates because the economy is re-accelerating.
If anything, that CPI number at 0.2 percent really puts PCE somewhat in the 0.2 percent range, which continues, if you will, the disinflationary, albeit a slower disinflationary timeline, but a move where you can continue to see yield at least go in the direction that the Fed hopes to see, towards 2 percent. Certainly a lot of debate as to whether or not we'll get there, but at least we're still dis-inflating from the perspective of how the market has priced it, particularly in the options world.
We saw within a very short period of time expectations that we were going to get a rate hike sometime this year, using option skew kind of as our guide, go from about 20 to 25 percent down to 10 percent over the course of the last week. I attribute kind of this rally in yield, most driven by that, you layer on the fact that maybe some of the first sets of emergency orders were a bit more measured from the administration with regard to tariffs.
Throughout all of this, we've got the uncertainty of what Trump policy means for the economy. It's an uncertainty, it's an unknown. That term premium that you would want built into it. It's more sanguine and one day certainly isn't a trend in this instance. It does give you a view of, you know what, maybe I should take a little bit of the most extreme pricing out of it. But I do think the data has been a bigger part of the move over the past week relative to administration, which you know, really still the first hundred days is going to be telling.
TG: So we're coming away from oversold conditions to a degree I think.
How much further do you think the bid in bonds can last? Is this just a modest position adjustment as you say, in response to some better inflation data? Or can we even go back not to necessarily where we were in September, but maybe the middle of the range we've had since then, another 20, 30 basis points or do we stop?
ML: I do continue to have concerns around term premium. So from a 10 year perspective somewhere 4.50 percent to 4.75 percent feels like a fairly well priced area given some of the continued uncertainty as to whether or not we're going to get back to that 2 percent inflation target. Whether or not there are some really longer term structural issues that might come out of administration policy.
The way I would play that is really looking at potential stability at the short end, maybe a little bit more convexity in terms of the belly outperforming. All of that for spread players if you will, still speaks to a curve steepening whether or not we look at it from a five 30s perspective, expecting the belly to really be the bigger driver of lower reacceleration risk and or twos tens just because it's so easy to put that trade on. You'll still get kind of the flavor of the curve steepening if in fact that happens. But when it comes to that 10 year yield, I do think that ongoing debt sustainability, fiscal sustainability deficits, which are unprecedented given the amount of growth we've had in the economy and the amount of growth that's expected in the economy is something that is still keeping foreigners away from our bond market to a certain degree.
TIC data as well as our cross border flows do show that either they're selling coming out of some of the larger Asian markets and or a reticence for the cross border real money investor to engage back in a way that they had really kind of going through a lot of the volatility while the Fed was hiking rates to be honest.
TG: Well, let's talk about those deficits and as you were speaking I thought of the title for this podcast which I think is going to be something on the order of Trump versus the bond markets and who wins?
ML: Excellent. How can, how can that not get the most hits?
TG: Well, I'm trying to help you here, Marv. You got to get that. It really has everything. Bonds, Trump. If we had Taylor Swift, we'd have everything. I think in a viral, we would.
ML: Blow up the universe if that was.
TG: we really would. It'd be Kardashian-like. Scott Besant, the new Treasury Secretary. He has a 3 percent deficit target and you've spoken about the need for term premia to be assigned to a greater degree to account for larger than 3 percent deficits. In fact, deficits are going to be much larger than that in the short term.
But do you think 3 percent as a long-term aim is realistic for deficits?
ML: Given the way the administration is talking about an extension of the tax cuts from Trump? One, I don't see how mathematically you get to a 3 percent deficit, even if you get above trend growth, which certainly is something that we're reevaluating. You really do need it to be both a revenue and an expense part of the discussion. Tariffs wound up being an interesting wild card. You know, I really worry about whether or not a more aggressive, universal approach to tariffs is a little bit misaligned from the perspective that you could get this revenue without impacting growth. So I do think that there are offsets associated with that.
But unless you really address the revenue side of things as well as the expense side of things, I don't see how you get to 3 percent. And then really in a term premium-rich world, that interest component becomes a bigger and bigger part of ultimately the deficit and really the fiscal stimulus to a certain degree.
TG: In his testimony to Congress last week, thinking about the tax cuts specifically, that will contribute to any future deficits that have the likelihood, as you mentioned, of being extended in Trump's second term, he described the failure to extend those tax cuts as a potential calamity. And I think he's coming at this not from the deficit perspective, but from the growth side of things. Do you think that holds water as a description?
Would it be a calamity if these tax cuts weren't extended for some fiscal concern reasons?
ML: I mean, I think it would have a significant impact on GDP. You know, calamity might be, might be a little bit grandstanding, you know, particularly in front of, in front of Congress. It's not necessarily surprising from that perspective, but I believe the figure is about US$4 trillion that would ultimately be reversed and that would be a significant impact on the economy.
So we would have a growth Impact, for sure. I don't think that irrespective of who won the White House, kind of thinking back to early November or early fall, if you will, an extension of a certain portion of those tax cuts was always going to be pursued by either party, if you will. So I do think that there is acknowledgment that it would ultimately slow growth. And if we don't extend any of it, slow growth, notably whether or not it's a calamity that's a little bit overzealous, it would have an impact for sure.
TG: Okay. Well, bringing things to a close here and thinking about market functioning, actually. Last week's guest, Ron O'Hanley, talked about a worry that you'd see. He called it a kerfuffle, which I thought was a very British expression for talking about US bond markets. But I liked it. I liked it. A kerfuffle in the treasury market because of deficit concerns. That was where he wasn't worried about debt levels or deficits necessarily, but that market functioning might get impaired because of this large issuance that's coming.
You talked about foreign demand potentially stepping back or already being weak, but potentially stepping back further. You have the Fed still. We're going to talk about the Fed as well at the end. But the Fed in the background is running quantitative tightening, that is the shrinking of its balance sheet by letting treasuries roll off. They are not marginal buyers anymore.
How worried are you about a potential market disruption because of some of these factors? If you disagree with Ron, we can take it out. We won't hurt you here.
ML: The treasury market from a functioning perspective is amongst the most observed market out there. The Fed has teams of market analysts as well as economists that are looking at the minutiae of funding and looking at the minutiae of how treasury securities are traded. You never know if you're in a systemic risk perspective often until you do have systemic risk in the market. Having said that, it would be to a market that's analyzed at infinitum by a lot of people, both on the quasi-governmental side of things.
From a policy perspective as well as analysts like myself, there are a lot of troubling aspects in the treasury market right now. Everything that you mentioned is certainly something that we should be concerned with. The amount of overall debt that's sitting on primary dealer balance sheets and the ability of those primary dealers to intermediate other parts of the market. Really thinking about funding, thinking about the repo market and volatility around the repo market specifically because there are so many treasury bonds out there. These negative swap spreads that we're all looking at on the rate side of things from a more minute perspective just shows how unattractive owning nominal treasuries are relative to the concept of what rates can do.
And then ultimately the fact that we haven't really seen the risk aspect of treasuries function the way they normally would in a risk off environment, if you will. And we've had various periods over the last quarter to two quarters that you would have expected a better bid. At the long end, none of that's working. And from that perspective you really do have to be concerned that we're going to at some point this year wind up in a situation that we didn't expect because of not only the amount of debt that's out there, the amount of debt that could be issued, and the fact that market functioning right now doesn't really feel that healthy before a new administration that might have a lot more treasury issuance for us to worry about.
TG: Okay, so to wrap things up or to start to wrap things up, because I still want to get a quick Fed view from you at the end. We have at the moment, as I mentioned, Fed policy rates are in the range between four and a quarter and 4.5 percent two year yields are basically about the same 4.26 I think as I look at them now, 10year yields at 4.56 percent. We've talked about the evolution of 10 year yields going from 3.70 percent all the way up to 4.80 percent and now coming back 20-25 basis points.
Simple question, do you think we will end the year with higher or lower yields from here?
ML: I think that the curve will steepen. I think that the 10 year has the absolute chance to touch 5 percent. But I do think that from a Fed pricing perspective we're going to take more of the hike discussion out of the curve and we're going to potentially put more cuts into the curve. So I would think that that two year particularly maybe out to rally would outperform but really continue to have concerns around term premium given everything else we talked about and the fact that the amount of debt issuance can continue to increase unless we get some more fiscal sustainability coming out of Washington, which really doesn't look like it's their primary concern.
TG: And so is 5 percent just the automatic buy zone for you? You just load up whenever it gets there or do you look for an overshoot to.
ML: I, I look for like everything and I'll be greedy about it. I'll look for a little bit of an overshoot. You know, if I have five and a quarter, five and a quarter, I probably do start loading up on things.
TG: Yeah, fair enough. Well, very, very quickly at the last you mentioned pricing for the Fed to potentially start to add cuts back in because we have effectively taken almost all the cuts for this year out that they're projecting. We're priced maybe one, one and a half and really over a 12 month time horizon that is de minimis.
What message do you think the Fed's going to give us next week? Bearing in mind there are no changes to projections or anything. But what message do you think they will give?
ML: They're going to remain data dependent. I think they're going to say that the data is proving a little bit stickier than they expected. They're going to pause, but they are still going to be able to reach their 2 percent target. So he's going to stick to those dots, which continues to show rate cuts in the second half of this year with the view that they're still going to be able to reach their policy targets.
TG: Fantastic. Well, Marv, I think we have covered all the hotspots, all the things that we need to make this a viral episode yet again to get you your top spot back.
ML: I did my best.
TG: You did. We've got bonds, we've mentioned Trump. We've got a good title. That should do it, I think. Thank you as ever for your insights.
ML: Excellent. Thank you, Tim.
TG: Thanks for listening to this week's edition of Street Signals from the research team at State Street Global Markets. This podcast and all of our research can be found at our web portal, Insights. There, you'll be able to find all of our latest thinking on macroeconomics and markets where we leverage our deep experience in research on investor behavior, inflation, risk and media sentiment, all of which goes into building an award winning strategy product. If you're a client of State Street, hit us up there at globalmarkets.statestreet.com and again, if you like what you've heard, subscribe and leave a review. We'll see you next time.