Using Fed Projections To Infer The Term Premium?

I was passed along the article “Views from the Floor — Tighter and Tighter” by the Man Institute published last month. It discusses using the FOMC long-term projections to infer the term premium in the 10-year Treasury yield.

The methodology is straightforward (I have a busy week, so I have not gathered the data to replicate it myself). They describe it as follows:

A better approach is to incorporate the FOMC’s projections of the Fed Funds Rate into the expected path of short rates. This will make term premia estimates more consistent with sub-2% growth. Figure 1 shows that model applied, with an expectation that the short rate matches the Fed Funds Rate over the next year, then it linearly converges to the long-run projection over the next three years, and then remains constant.

"So How Did You Lose Money Buying Risk-Free Bonds?"

The title of this article is deliberately silly, but there are times where I just need to be deliberately silly. I am not going to discuss why people (like myself, sigh) decided to not cut their bond allocations to zero ahead of the recent Bond Catastrophe, but rather how to judge or even calculate returns based on the most common bond market data — constant maturity yield series.

(This article is a bit rushed, since I yet again have family visiting from out of town…)

Slopes And Recession Probabilities

Menzie Chinn just published a short note “Inversions, Bear Steepening Dis-Inversions, and Recessions.” He was responding to an article that argued that a bull steepening is a good sign for the economy, as it indicates less need for the Fed to cut in response to a recession. Chinn updated some recession probability indicators based on the yield curve.

Comments On Logan Speech

Lorie Logan of the Dallas Fed gave a recent speech in which the term premium figured. Although I think Logan’s remarks are fairly innocuous, I saw some chatter that extended to a “oh no, fiscal!” story.

At Least It's Not As Bad As 1994

The current Treasury bear market has been impressive, and unfortunately for the bond bulls, there is no valuation reason for it to stop. For example, the 5-year Treasury is still trading well below the overnight rate. If we look back to the 1994 bond bear market, the 5-year traded about 250 basis points above cash — versus about 100 basis points below now.

Decoupling

Although I am not a forecaster, I periodically comment on what I would probably be looking at if I attempted to do so. Right now, the interesting thing is the possibility of a decoupling between Europe and the United States. The latest round of U.S. data has been strong, the Fed has hiked rates again, and Fed analysts apparently have thrown in the towel on recession risks (oh dear). Meanwhile, survey data out of Europe (particularly Germany) has been weak. The chart above shows what I hope is the current (not forward looking, which is less negative) demand for loans by firms in the euro area. (I write “hope” because I had to pick the series out of a somewhat confusing list on DB.nomics, and the ECB Bank Loan Survey only showed recent data to compare to. In case it is not obvious, I am not a European data maven — previously, I worked with commercial data sources where it was easier to pick out the “standard” series.)

Is it possible that Germany and/or the euro area have a recession without the United States having one? I am not forecasting that outcome, rather I want to discuss why the possibility is interesting from a bond market behavioural perspective. (Although if the U.S. continues to avoid recession — “ha ha” to all the yield curve fundamentalists.)

Advantages To Procedural Changes In Bond Market?

From my recent Torrens Zoom call, I ran into questions about procedures in the government bond markets. The main question was whether I saw potential changes to the markets to improve things. The second was more of a concern about the complexity and opacity of the bond market.

Yield Curve Control Blues

The Bank of Japan surprised people with a change to its yield curve control (YCC) policy. This has caused a mild sell-off in Japanese bonds, with the 10-year Japanese Government Bond (JGB) yield up 15 basis points on the month when I last checked.

Although I think some of the usual suspects have tried to get excited about this — a harbinger of doom to Japan and/or the global fixed income complex! — this is still in nothingburger territory. (Note: people who discuss bond yield changes as a percentage of previous yields — e.g., “bond yields rose by 100%!” when the yields go to 0.2% from 0.1% — are innumerate clowns and are safe to ignore.) Nevertheless, if the yield cap was raised by a lot more, there would be a lot of wailing and gnashing of teeth.

One standard dodge of a forecaster is to say that this might be important for global bonds. This makes one sound like a very serious forecaster with an eye on those darned black swans. However, any number of things can cause global bond yields to rise. If you want to be a yield forecaster (I don’t!), at some point you have to put your money where your mouth is and either recommend long/short positions and/or option strategies (if you want to position for tail risks). Although I am not a forecaster, I see no reason why I would change any non-Japanese market views as a result of these recent events.

Achilles Heel Of YCC

Yield curve control is a popular discussion point, particularly for Modern Monetary Theory types. My view is straightforward: yes, the government can make yield curve control stick. The problem with the policy is when the yield target is revised.

With short rate targeting, the central bank is not directly causing capital gains and losses for bond holders. Sure, they cause carnage, but they have plausible deniability: bond yields are set in the market, we are just setting the overnight rate! Sure, it’s stupid, but plausible deniability is still plausible deniability. On the other hand, with yield curve control, the central bank is directly handing out mark-to-market losses to widows, orphans, and pension fund bond managers. That’s a pretty potent political coalition burning you in effigy on the steps of the central bank’s main office.

It is also a financially unstable policy. A short-rate pegging regime works because forwards represent a market-clearing level in the private sector. Only an academic or central banker would be delusional enough to believe that central bankers can plant “expectations” where they want by announcing shifts to their views. In reality, the forwards represent the average guess as to how wrong the central bank’s forecast it. Once the central bank starts planting forwards by decree, market participants only have it a “take it or leave it” decision. If the forwards are too low, they dump bonds en masse — also known as an attack on the yield peg.

Needs Institutional Support

Anyone who has been paying attention to central banks has noticed several allegedly “permanent” self-imposed policy regimes by central banks over the past few decades (being a more detailed regime than the looser statutory inflation-targeting regime), each being abandoned whenever it became inconvenient. The lesson is that the only credible monetary policy regime is one that is backed by statute.

That is, the only way yield curve control is going to be a stable long-term policy is that it has to be set by law — and the rest of economic policy needs to be coherent with the policy. My view is that we are nowhere near a situation where policy is coherent with YCC, which is why I am not enthusiastic about the policy.

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(c) Brian Romanchuk 2022

Initial Comments On Sissoko Paper: Money Markets

I ran across Carolyn Sissoko’s working paper “Financial dominance: why the ‘market maker of last resort’ is a bad idea and what to do about it” (link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4240857). Although I agree that non-bank finance (“market-based finance”) is going to be the source of financial instability under current institutional arrangements in the developed countries, I am not too sympathetic with her framing of the issues. Private sector balance sheets have been tilted towards non-bank finance as a result of institutional and demographic trends, and the traditional banking system has been de-risked courtesy of banks relying on tools provided by non-bank finance.

Slope Inversion: What's Next?

Although it is safe to expect that the yield curve tends towards flattening during a rate hike cycle, the current movement in the 2-/10-year slope is relatively dramatic (figure above). This article discusses some of the mechanics of how slopes are traded.

Treasury Market Pricing

The Fed surprise 75 basis point hike last week blew Treasury yields out, with a small reversal at the end of the week. Such a reversal is typical after large moves. In this article, I just want to discuss the big picture of Treasury pricing.

The figure above shows the post-2000 history of the 2-year Treasury yield. What we see is that the rise in yields in 2020 has been extremely violent when compared to previous behaviour. This fits in with market commentary pointing out that Treasuries have seen the worst short-term drawdown in decades.

The figure above shows the history of the 10-year yield over the same period. In this case, we can see that the recent move is still large, but its past history shows more volatility.

Risk-free rates are literally the simplest instrument to price in finance, and so the rates market ends up being closer to the theoretical ideal of “efficient markets”: rapidly changing price as new information comes in. If we eyeball the 10-year yield, we see that there are periods of range-trading that end with rapid movements to new levels. This behaviour is the worst possible behaviour for technical analysis, since mean-reversion trades are punished during the violent moves, and trend-following is punished when range-trading. This is somewhat different to commodity, equity, and foreign exchange markets — since “fair value” is somewhat nebulous, we quite often run into trending behaviour.

If we go back to the 2-year yield, it does appear to follow trends, with the recent experience being an outlier. This was the result of “gradualist” interest rate policies. The Fed used to be in one of three modes: on hold, hiking by 25 basis points per meeting, or cutting rates in a panic. As such, most of the time, market pricing for the Fed tended to be correct — it was only transition between “modes” that changed pricing dramatically. As such, most profits/and losses versus forwards were concentrated in short period when the mode being priced shifted.

The current rise in the 2-year rate was more rapid since the market pricing was wrong-footed from two directions: the terminal rate was rapidly revised higher, and the pace of race hikes is double (or triple!) that of recent cycles.

In other markets, the tendency to get increasingly bearish as prices fall can be rewarded at times. Should we extrapolate past losses forward? The issue here is that we need to keep in mind the simplicity of rates pricing. To keep moving the 2-year, we need to keep pushing up the Fed’s terminal rate. Is this plausible?

Recession Calls Everywhere

I do not follow street research, but I am seeing a drumbeat of recession calls on economics/finance Twitter. I certainly have sympathies for a recession call — but I remain cautious about the United States/Canada (as opposed to other countries with worse energy supply outlooks). Recession risks are the main obstacle for bond bearish positions: it is hard to see the Fed hiking to 4-5% if the global economy implodes in the next couple of quarters.

The 2-/10-year slope snapped back on Friday, but it is flirting with inversion. Although economists love to discuss the 2-/10-year slope as the result of the bond market pricing recession odds, it is the spread between two pricing benchmarks. Bond investors get paid based on trading profitably, not whether recessions are declared.

The current situation is a bit hard to interpret. The reason for a near-run inversion is that the 2-year is pricing another slug of rate hikes. If we are to take pricing at face value, all that is expected to happen is that there would be a small reversal of rate hikes in a couple of years.

Such an outcome is not impossible, but I believe it is only consistent with a “soft landing” scenario: the Fed hikes rates to around 3%, inflation is tamed, and there is no recession over the next year. Otherwise, one benchmark or the other is wrong: the Fed keeps hiking rates to contain inflation, or we have a hard landing and they are forced to cut. The bond bears are attracted to shorting the 2-year, and the 10-year is attracting the bulls.

One theoretical wrinkle on the “yield curve predicts recessions” debate is a scenario of a very rapid meltdown in activity. If it happened soon enough, it could take out a lot of the priced rate hikes — steepening the curve ahead of a significant inversion. I am not convinced that this will happen, but it is clear that it could happen.

War and Commodities?

The situation on the ground suggests that there will not be a rapid end to hostilities, as the Ukrainians have indicated multiple times that they intend to counter-attack on a greater scope towards the end of the year. Until the fate of that counter-offensive is known, there will be no serious peace talks.

Even once fighting reaches a lull, it would take time to formulate a peace deal — assuming that both sides are interested in a deal (which could easily not be the case). As such, the commodities markets will be disrupted for some time.

We should see greater rail transport of Ukrainian wheat going forward, but that will take time to organise. Russian oil appears to be making its way to market via third countries. As such, it is possible that the oil situation has entered into a new steady state. Natural gas piped into Western Europe seems to be the main uncertainty in the near run. Over the longer term, if Russian supply is shut it, their long-term production capacity needs to be revised lower.

As such, it is hard to see too much relief for global energy prices in the absence of more meaningful demand disruptions. 

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(c) Brian Romanchuk 2022

Where Are Supply/Demand Curves?

The reduction of the Fed’s balance sheet is coming, and so we are likely to be involved in debates about how much this will affect bond yields. I am in the camp that the quantities involved do not really matter (which some qualifications). I just want to explain my logic, which involves discussions about “supply and demand” curves for bonds, which vary based on time frame. Although this discussion might appear obvious, my feeling is that there are some hidden assumptions that people make about market price determination.

Fed Flattens The Curve

I have been taking it easy for the past week, courtesy of dealing with a mild COVID-19 case. (It largely felt like a cold. However, some symptoms persist, and so I prefer to rest and let them clear.) During my down time, the Treasury market (along with other govvie markets) have been crushed. Fed policymakers have signalled that they want to ramp up the pace of hikes — which surprised me.

Incoming Fed Rate Hikes

Inflation data in the United States came in surprisingly hot, and so rate hike chatter went off the charts. I think the idea of a “surprise” inter-meeting rate hike is silly in the context of modern Federal Reserve operating procedures, but I now see more chance of an initial 50 basis point rate hike in March as an attempt to assert dominance.

Central Bank Confusion

The Fed and Bank of Canada announced that they were on hold yesterday, but signalled that rate hikes are likely hitting in March. From what I have seen of chatter on Twitter and various editorial pieces, this has caused some confusion. (I am not sure what street research is saying.) This article is a grab bag discussing what I saw as common (or at least popular) points of confusion, as well as some of my editorial comments.

"The Term Spread As A Predictor": Comments

I just saw a reference to a recent article by Dean Parker and Moritz Schularick: “The Term Spread as a Predictor of Financial Instability.” The article use the Macrohistory Database by Jordà, Schularick, and Taylor to look at the behaviour of the term spread (slope) between the 3-month rate and the 10-year bond yield in a number of countries over a long history around recession/financial crisis events. As expected, the slope inverts ahead of the event. They then looked at adding other factors to create a financial crisis predictive model. My article here are more general comments about the term spread behaviour.

(This is the first time I ran into anyone using “term spread” instead of “slope.” One could argue that it is a better term than slope — in other contexts, a slope is a rate of change, while a yield curve “slope” is a level difference between two points on the curve. Although it might catch on with the youngsters, I see having two words instead of one, with both of those words having multiple uses within fixed income, “slope” is more convenient for writing. In any event, either is infinitely superior to the practice of (mainly older) economists using “yield curve” to refer to a particular slope, when the yield curve is itself is the plot of yields versus the continuum of maturities.)

Understanding Long End Inversion

I have seen a certain amount of chatter about inversions of the long end (or ultra-long end) of the Treasury curve. I do not have enough information to offer definitive conclusions on recent market action, but in the article I explain why I view a 20-/30-year inversion is not comparable to a 2-/10-year inversion.

Why I Don't Buy Demographic Interest Rate Stories

There has been a couple of articles that have attracted attention recently in the area of interest rates. Matthew C. Klein offered a summary of them in “Inequality, Interest Rates, Aging, and the Role of Central Banks.” The first paper was by Adrien Auclert, Hannes Malmberg, Frédéric Martenet, and Matthew Rognlie, and the second by Atif Mian, Ludwig Straub, and Amir Sufi.

Why I Am A 5-Year/5-Year Bug

I entered into a private conversation about techniques that academics use to isolate the alleged effect of fiscal deficits, quantitative easing, (etc.) on bond yields. I tend to be somewhat skeptical about such attempts, but there has been some work done that looked more reasonable. (I probably should highlight that research, but I would have to get back to it at a later time.) My argument is that if you want to any research in that area, you want to go after the 5-year rate, 5 years forward (or a qualitatively similar forward). If you can explain that rate, I would be interested.

For Bond Bears, Patience Is A Virtue

Most discussion of the Treasury market coming from people who are not rates strategists involves hoping for or predicting the collapse of the bond market. Nobody likes rates to be this low, and they are an insult to those people who studied Economics 101 and are certain that bond investors have the constitutional right to demand a particular real rate of return.