MorningWord 4/21/17: Yields Throw a Curve

by Dan April 21, 2017 9:16 am • FREE ACCESS

Yesterday, our friend Peter Boockvar of The BoockReport had some interesting commentary regarding the Fed’s intention to tighten monetary policy (emphasis mine):

After hearing Fed President Eric Rosengren yesterday afternoon again giving his support for allowing the balance sheet to “start the roll off now” as “we’re basically at our employment mandate and we’re basically at our inflation mandate. So ideally we don’t have to manipulate the yield curve” as he joins a growing line of Fed members that are supportive of reducing the size of their balance sheet, I realized one word has been missing from all of their comments on this important issue. We’ve heard ‘shrinking/trimming the balance sheet’, allowing it to ‘roll off’, and ‘gradually removing accommodation’. We haven’t heard that this is another form of ‘tightening.’I’m thus going to call it what it is, Quantitative Tightening, QT. No more shrinkage comments from me which I know you thought of that Seinfeld episode when you did.

While the fed funds futures market has reduced the odds of a June hike to about 50%, nothing tells me that the Fed wants to back off from moving again in June. I mean if they’re talking persistently about QT and that won’t start after more rate hikes, then we’ll get more rate hikes. Voting member Robert Kaplan today says because he expects a GDP pickup in Q2, he still sees two more hikes. But data dependency hasn’t gone away as he also said they can slow that down if the economy softens, and vice versa. Thus, 2 more hikes this year is his “baseline” scenario. By the way, Kaplan referred to QT as ‘balance sheet unwind.’

What’s truly amazing to me as that in the face of a near-certain June rate hike, the third since December, and only the fourth in a decade, and now the talk of QT, that the yield on the 10 year treasury bond is has gone from just above 2.6% in March to its current 2.23%, while the yield curve has flattened to a point causing some to fear the disconnect between long term and short term rates might be signaling a coming economic slowdown. For a little refresher, on April 1st, Sam Goldfarb of the WSJ  laid out why the flattening might imply growth concerns:

A flattening of the Treasury yield curve in 2017 is a worrying sign for investors banking on resurgent U.S. inflation and growth.

Long-term Treasury yields, which are largely driven by the U.S. economic and inflation outlook, have declined modestly this year, following a sharp rise in the wake of the November election of Donald Trump as president. The 10-year U.S. Treasury yield has fallen to 2.396% from 2.446% at the end of 2016.

At the same time, short-term yields, which are more influenced by monetary policy, have risen in 2017 as Federal Reserve officials have made clear that they expect to continue raising the fed-funds rate through the rest of the year.

As a result, the yield premium on the 10-year note relative to the two-year note—known in the market as the 2-10 spread—slipped Wednesday to 1.107 percentage points, its lowest level since the election, though it ticked up to 1.138 percentage points Friday.

Which brings us back to why yields began to rise in the first place, first the prospect for an improving economy pre-election, and the continued rhetoric towards tighter policy throughout 2016, and then post-election the hope for a legislative agenda that would accelerate growth throughout 2017. But as Goldfarb points out:

Expectations for higher long-term yields and a steeper curve rested on two pillars: first, that the economy on its own was showing signs of improvement, and second, that it would get an extra lift from promised tax cuts, infrastructure spending and regulatory relief.

At the outset of the second quarter, both of those pillars are still standing, yet neither is looking as sturdy as before.

Last evening the WSJ’s James Mackintosh echoed a similar tone to Goldfarb from a few weeks earlier:

The sharp drop in government-bond yields is the most obvious signal that something is amiss. It is backed up by ominous signs from raw-materials markets, where copper and iron-ore prices have tumbled, and a swing in leadership of the stock market away from go-go bank shares and cheap “value” stocks to safety-first utilities, real estate and companies with high-quality balance sheets and reliable earnings. All this has come as inflation expectations priced into bonds have fallen and as some weak data has led to downgrades of economic forecasts.

Technology stocks’ return to favor also suggests investors are looking for companies able to deliver growth even if the economy is weak.

I think the last point is the most important one, and one that I have on numerous occasions this year, Wednesday highlighting the crowding in a handful of mega cap tech stocks that have driven a disproportionate amount of the S&P 500’s (SPX) ytd performance:

As far as large cap stocks, they are seemingly a crowded trade, per the WSJ yesterday, emphasis mine:

Technology-oriented companies dominate the list: Apple, the world’s largest company by market capitalization, is up more than 22% this year through Monday. Social-media company Facebook Inc. has risen nearly 23% while e-commerce powerhouse Inc. has climbed 20%.

Combined, shares of these three companies account for almost one-third of the S&P 500’s 2017 advance through this past Wednesday.

The recent strength in tech and internet companies marks a reversal from late last year, when investors piled into banks, industrials and small-cap stocks in the weeks following November’s U.S. elections.

I am just a dopey stock and options guy, so maybe all this yield curve stuff is a bit above my paygrade. But something sure does smell fishy. Think back to May/June 2013 when the Fed first floated the trial balloon of merely tapering QE bond purchases, the ten year Treasury yield made a b-line for 3%, while the 2 year went to .43 bps vs today at 2.23% and 1.18%, I’ll let you do the math on the spread. The main point I would make is that the SPX went from 1660 to 1560 in less than a month of the prospects of the Fed merely pulling back on QE as the yield curve widened. With the SPX now at 2355, and the yield curve flatter (with 10s much lower and 2s much higher), there seems to be little cares in the world, and few risks priced into equities. I guess the worry is that the Fed is engaging in QT and rate increases at a time where the economy may be weakening, or merely not able to handle tighter monetary policy, and if that is the case with the strong likelihood of a massive fail in 2017 on the new administration’s promise of pro-growth policies, then at current valuations, equities could be very vulnerable to a surprise shock coming from no shortage of directions.