The ripple of turbulence provoked by the February bond selloff could be a taste of what is to come later this year.
If the vaccines are successful in putting the pandemic behind us — and the US economy really starts to gain traction — it is possible that capital markets could truly start to rumble.
For rising yields, pace is important. Most seem to agree that the cause of February’s market turbulence was the speed of the selloff in Treasuries, not the direction.
Equilibrium yields and rates should go up as the economy reopens. Chinese 10-year yields renormalised to pre-pandemic levels by September 2020 because the domestic economy recovered quickly due to prompt control of the outbreak through strict social isolation compliance as only China could enforce.
In the US, 10-year Treasury yields also finally renormalised to pre-pandemic levels last month, coinciding with the level of real gross domestic product (GDP) more or less regaining its 2019 high-water mark.
That was essentially Federal Reserve (Fed) Chair Jerome Powell’s message in late February when he refrained from giving any sign of possible intervention in the bond market.
With credit spreads near record lows, it is hard to make a case for any kind of financial stringency in the marketplace.
So far, the rise in yields is in line with the restoration of pre-pandemic levels of activity in real GDP.
The bull story is that as long as yields increase gradually or at least in step with the pace of economic renormalisation, capital should rotate from long-duration assets, like the big-cap growth stocks, into deep-value cyclical and small-cap equities while nominal GDP recovers.
If for some reason the rise in interest rates is more rapid, there could be volatility. During late February, for example, the turbulence caused by the bond market was enough to pull the broad market lower, not just the bigcap growth stocks, at least briefly.
What is keeping bond yields in check?
The story is more complicated. There is no denying the scale of Fed Treasury purchases. Yet, previous quantitative expansion of the balance sheet has been associated with rising bond yields, which is the case again. In addition, the dollar should be a lot weaker if the Fed is artificially depressing real interest rates below equilibrium.
Instead, the dollar is off a measly 5% from where it started in 2020 despite trillions in balance sheet expansion, an historic regime change in US monetary policy and budget deficits to kingdom come.
The relative stability of the greenback in the face of these developments speaks to an underlying enormous demand for dollar liquidity. The case for higher long-term inflation expectations and bond yields seems on hold without a significantly weaker dollar.
In my view, the demand for dollars is coming from the private sector. US rates remain attractive relative to other countries, which encourages foreign capital into dollars.
However, the biggest source of dollar demand comes from US domestic capital. The collapse in the velocity of money, the surge in bank deposits, and dramatic increase in household savings all point in the direction of an extraordinary increase in the demand for dollar liquidity.
Most of this private sector money has supported Treasuries. Bank deposits soared by several trillion, which banks used to buy Treasuries and then sold to the Fed. Those Treasury securities have been replaced with excess reserves.
The Fed effectively has taken in notes and bonds in exchange for Treasury bill-like instruments, called excess reserves. These excess reserves are not money in the usual sense since they can only be held by commercial banks, and they remain dead money to the economy unless loan demand picks up.
This action to accommodate the public’s demand for dollar liquidity was able to stop and then reverse the move higher in the dollar last March.
However, the net effect has only left the dollar marginally lower than it was at the start of 2020 and bond yields at about the same level.
Confidence, Fed reaction are key to what comes next
Unlocking this extraordinary demand for US liquidity is the key to gauging when the next leg of the US bond bear market will take place, and if or when the dollar is ready to swoon.
Market drivers will be confident and the reaction of the Fed. It was fear of the pandemic and government-ordered lockdowns that drove the demand for liquidity in the first place.
It makes sense that relief over the pandemic’s end and green lights from governments will be the keys to unwinding some or all of this unusual dollar demand.
How the Fed reacts to this development will be an important part of the story concerning bonds and the dollar.
If it stays true to current guidance, failure to react to a drop in the demand for dollars without curbing balance sheet expansion amounts to another flush of stimulus.
Eventually, the Fed will react sensibly but will be late. If Dr Anthony Fauci — a world-respected figure during the Covid-19 crisis — is correct and the stadiums are full in September, the biggest rumbles in the latter part of the year may not be on the football field
