We have already commented these days that the rise in bonds over the past few weeks was due to very complex causes. Like reactions to the problems of the liquidity markets, where there is a lot of excess, due to the rotations of the big pension funds, because the FED is buying more bonds than it has issued in recent months.
All of this is clear to us. They don’t give correct information to the right ones.
But in the last 48 hours, bonds have had another reaction which, in this case, sends us some very valuable information that most investors ignore.
The important reaction I am referring to is the sharp flattening of the yield curve after seeing the new market attitude. This violent phenomenon cannot go unnoticed.
And to understand what bonds tell us, the first thing we need to define is that this is the neutral interest rate in an economy. A few years ago, El Economista defined it in a simple and easy to understand way:
It’s the nickname for the short-term inflation-adjusted interest rate, which fits with the use of all economic resources, keeping prices within the central bank’s 2% target. A monetary policy that neither slows down nor stimulates economic activity. The calculation of this figure varies according to estimates and factors, so this rate remains a somewhat abstract concept.
As well as. According to a Deutsche Bank newspaper, the message that bonds send us with this flattening is that bonds, despite what the FED says or precisely because of this, become very negative on the neutral rate. In short, they see a possibility of an increase in interest rates, quite the opposite of what might appear at first glance, very limited, before the FED upsets the economic balance.
See what Deutsche Bank says.
The market has seen a noticeable flattening over the past 48 hours. This is extremely unusual given that the Fed has not even started to raise rates. Market prices for the 2023 and 2024 hikes have increased, but yields beyond them have declined (Chart 3). It also coincided with a notable drop in inflation expectations; in fact, we noted yesterday that the Federal Reserve showed a falcon pivot even before market breakevens hit their normal pre-2014 range. What all of the above tells us is that the market is extremely pessimistic about neutral real rates, or *. If the Fed decides to go ahead, the market says it can’t go very far
This type is also called r * and appears in Taylor’s famous formula:
r = r * + [ 0.5 · (PIBe – PIBt) + 0.5 · (ie – it) ]
r = target interest rate
r * = neutral interest rate (normally 2%)
GDPe = expected GDP
GDPt = Long-term GDP trend
i.e. = expected inflation rate
it = neutral inflation rate (normally 2%)
Well, this r * or neutral type, where the economy is functioning perfectly, is tumbling down at full speed for bond traders, who are the finest in analysis because here there are no robinhoods doing science fiction films, it’s a market with strong hands.
Two other very valuable quotes from the work of Deutsche Bank. And be careful because in the first one he gives us the explanation of something that I myself commented on in the video of the 4 keys of the week and in the closing video of Friday, as I did not understand: the rise of technology. See, it’s really interesting:
In other words, a low overall r * (remember the rest of the world continues to have huge current account surpluses, or excess savings) also lowers the r * of the United States. Second, a low r * is consistent with the continued resilience of stocks, especially growth stocks that are highly dependent on a low medium-term discount rate. It should come as no surprise that yesterday’s stock rally was led by huge relative turnover from Russell to NASDAQ. This is the price of secular stagnation 2010-19, version 2.
One-day price action is not trending, but the market is sending particular signals that should be watched. Over the past few weeks, we’ve been insisting that the transition from the V-shaped part of the recovery to the new post-COVID steady state will start to raise all kinds of uncomfortable questions, such as the structural damage that COVID has. left savings in private sector rates, as well as the new level of real equilibrium rates. Historical evidence has shown a huge negative impact of pandemics on r *, for example. For a major bullish cycle in the dollar to occur, the Fed must be able to go very far. The market is not that secure.
Very very interesting. We could sum it all up, as long as the links send us a message. They don’t believe the Fed has the capacity to raise interest rates much, if they can. And when they talk about bonds, you have to listen, for the moment they have a record of 100% correct answers, when, for example, after an investment of curves after a few months recessions still appear in the United States. However, the curves tell us not to believe anything in strong rate hikes:
Then the bonds go up
Then those that depend on types as technology advances
And the dollar does not seem to have much of a future in its rise.
We will be following this subject closely.
If you want to dig deeper into this exciting topic, I recommend you read this article from Zerohedge.com
In the article, they are very harsh and warn that the Fed could be on the verge of making a mistake it already made and very well documented at the time. See this quote:
As we then concluded, “this is the scenario of major policy error. because even a very shallow rate hike path could drive the real funds rate well above the short-term equilibrium real rate, further depressing demand. It is therefore plausible that the economy would enter in recession, and the Fed would quickly be forced to interrupt the rally cycle. By the way, such a policy error could be reinforced by causing structural damage that puts additional downward pressure on the equilibrium real rate. In this case, the rate would flatten significantly, at least until the Fed changes course by cutting rates.
Or this one:
And in a repetition of the cycle hiking aborted from 2015-2019, as market prices for increases in 2023 and 2024 have increased, yields beyond have declined
They also cite in the article, the newspaper we talked about before Deutsche Bank.
As if to start thinking… the situation is much more complex than it seems.
A * take note of this symbol, we may name it a lot in the future. Diabolical situation that the FED has in front of it, a debt of twenty pairs of noses which also influences which type is the neutral for the economy, high inflation and the hands very tied to take action. We’ll see what comes out of all this. Houston we have a problem!