VIPs
- Global short-rate yields have traded in a tighter band than their U.S. counterparts since the onset of the Great Financial Crisis
- The last time the global 2-year yield was over 2% was five years ago; it troughed near 1% in late September 2016
- The U.S. 2-year yield bottomed at nearly 20 basis points in 2011 with QE in full throttle; it continued to bounce along the bottom until first rate hike of December 2015
- Fed tightening during Yellen era moved at slowest pace in Fed history; the U.S. 2-year began to rise at a faster pace after the Presidential election heralded a faster pace of tightening and QT
- The 2-year is trading in the tightest range on record while CPI is expected to remain at 2.5% for the next decade; these support markets pricing in 2 ½ rate hikes over the next year, half of the 5 hikes suggested by Fed rhetoric
- At the current trajectory, a 3-handle on the U.S. 2-year is likely; Powell will focus on labor market data and not be swayed by market expectations for future rate hikes
There are “pain thresholds” and “threshold intensities”, the distinct meanings of which should not be confused or conflated. A pain threshold is subjective depending on the individual – one person might not yelp when her skin comes into contact with 120-degree heat, while a more sensitive someone might scream out in agony. This disabuses the traditional definition of, “the minimum intensity of a stimulus that is perceived as painful.” The level of the stimulus – in this case the water temperature – is thus the threshold intensity.
Both domestic and international investors will soon discover a threshold intensity of a different ilk, one gauged off the level of short-term interest rates.
Taking a simple average of the countries listed above, you have to go back five years to get to the last time the global 2-year yield was north of 2%. It’s notable that global yields have been less volatile since the onset of the Great Financial Crisis. Differing quantitative easing (QE) journeys are also evident. In late September 2016, when global QE was running at full throttle, the global 2-year troughed within 2 basis points – hundredths of a percentage point – of 1%.
Over five years earlier, as Wall Street returned to work after Labor Day 2011’s long weekend, the U.S. 2-year troughed at a barely discernible .1995%. The persistence and power of Fed QE was on full display. Yields ambled along the bottom until December 2015 when Janet Yellen embarked upon the most glacial pace of tightening in Fed history.
Recall the two consecutive Septembers in 2015 and 2016 when markets had fully priced in rate hikes only to be told, “Please hold” until December. It would not be until after the Presidential election that the 2-year began to rise in earnest as the Fed miraculously reversed course on shrinking its balance sheet and rate hikes arrived Greenspan-style, as if on autopilot.
It’s his capacity to surprise markets that will test Jerome Powell at the September 26th press conference following the rate hike rolled out at that day’s Federal Open Market Committee (FOMC) meeting. As our friends at Bianco Research have observed, the probability of a pause in the tightening cycle has risen to 36% from single digits early on in Powell’s tenure. Though no red flag is raised until this probability crosses 50%, it’s nevertheless alarming that markets are pricing in 2.5 rate hikes over the next 12 months, half of what Fed rhetoric suggests, as in 5 more bullets in the chamber to be fired.
“The widening or narrowing of the gap between markets and the Fed over rate hikes will come down to market-based inflation expectations, which have been stuck in the tightest trading range in history since February 2018,” Bianco noted. “Inflation swap caps/floors, our preferred metric, are still pricing in near 2-to-1odds headline CPI runs BELOW 2.5% year-over-year for the next 10 years!”
We know Bianco well. It’s rare that he whips out all-caps and an exclamation point in one sentence. That brings us back to pondering WWJD, as in, “What Would Jay Do?” Does he defy markets – the first Fed chair since Paul Volcker walked the halls of the Eccles Building to do so – and push through with rate hikes despite growing evidence that PPI has peaked, putting in its first decline in 18 months, and that CPI is following with the expected lag?
The bravado voiced by those at the Fed suggests consensus on the FOMC in favor of Powell doing the unexpected. With the 2-year at 2.78%, it’s no stretch that a 3-handle on its yield is a done deal if Powell flouts market pricing in deference to the unflinching strength in labor market data. There’s no nuance in wages at decade highs and record high small business confidence. By the way, a 2-handle on the global 2-year would be right behind its U.S. counterpart.
Do you take your chips off the stock market table and buy and hold a 3% risk-free U.S. Treasury for the next two years? Or do you stay in the S&P 500, that’s only 4.3-times its March 2009 low of 666, because you’re paralyzed by a fear of missing out and comforted by its 1.8% dividend yield?
A diversified portfolio’s protection fails if the market loses faith in the Fed put, the implied floor under stock prices Greenspan committed to on August 20, 1987. Markets are pricing in a Powell put. Fed rhetoric says otherwise as others on the FOMC align with Powell’s 2012 observation on lower for longer: “My concern is that for very modest benefits, we are piling up risks for the future and that it could become habit-forming.” Six years later, we know markets are addicted. We don’t know what Powell will do when pressured to inject the methadone only he is licensed to administer.