Forget that most consensus estimates regarding yield curve steepening and the short volatility position in the bond market “have been wrong almost every year since the financial crisis,” CSLA’s Christopher Wood observes in January 4 report “New Year assertions.” Those concerns regarding a “short volatility” position in the bond market were taken up by incoming Fed Chair Jerome (Jay) Powell in recently released Fed minutes and had been keeping more than a few investors and analysts awake at night.
Short volatility and its impact on the flattening yield curve
A significant number of professional investors and bearish analysts have been prognosticating regarding the effect of interest rate free market intervention – and the advent of negative interest rates – relative to potential mean reversion. Some have been expecting a rapid sell-off in the bond market, one that could result in significant volatility surrounding lingering concerns over the withdrawal of central bank quantitative stimulus.
This concern might have been most vividly illustrated by Balyasny Asset Management’s analysis the August 2015 market crash regarding this very risk concern. But during Yellen’s tenure, this became less, and care to the point fears over a lack of a Brexit deal now are seemingly more important, according to a recent HSBC investor survey.
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The topic was on the mind of incoming Fed Chair Powell. During an October 23-24 FOMC meeting, Powell confirmed the obvious: The central bank has a “short volatility position” to use risk management parlance from the hedge fund world. His exact statement indicates concern that natural economic buyers might have been pushed out of the market by quantitative forces:
Take selling—we are talking about selling all of these mortgage-backed securities. Right now, we are buying the market, effectively, and private capital will begin to leave that activity and find something else to do. So when it is time for us to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response. So there are a couple of ways to look at it. It is about $1.2 trillion in sales; you take 60 months, you get about $20 billion a month. That is a very doable thing, it sounds like, in a market where the norm by the middle of next year is $80 billion a month. Another way to look at it, though, is that it’s not so much the sale, the duration; it’s also unloading our short volatility position. When you turn and say to the market, “I’ve got $1.2 trillion of these things,” it’s not just $20 billion a month— it’s the sight of the whole thing coming. And I think there is a pretty good chance that you could.
When considering the limits of quantitative stimulus, Powell refused to be swayed by the needs of equity investors who don’t want to free ride to end. “Why stop at $4 trillion? The market in most cases will cheer us for doing more,” he said. “It will never be enough for the market.”
This is a frank discussion of the market intervention concerns fall along the lines of Jeffery Gundlach and other major fund managers who have expressed concern. Calling the moment when interest rate volatility occurs is a fat tail event where getting the timing right is the most difficult consideration in the analysis. Free market forces will eventually take over, and rates will rise above their repressed levels, it’s just a matter of when, is a thought expressed by several fund managers and market analysts. Powell appears to grasp this as one probability path to consider among many – and all will likely result in a market reaction.
Wood criticizes tax plan, says it won't create permanent CAPEX and is too heavy on financial engineering
From Wood’s analytical perspective, three rate hikes are the expectation in 2018, in line with expectations so long as the economy does not start to run too hot, which would change the predominate trading ranges. It might take short-term dollar rates to their upper band near 2.25%, a move that is expected to impact the yield curve. The TUT spread between the 10-year and 2-year US notes, which is currently at 52 basis points, is at its lowest level since October 2007. The yield curve spread, which is considered a barometer of economic activity to come, was 73 basis last year, by comparison.
As the stock market plows past 25,000 on the Dow and three strong GDP prints show growing economic momentum, Wood is skeptical of “meaningful cyclical acceleration in the US economy.”
Structural code changes were not made that would mandate investment in the permanent US economy, for instance.
While the tax bill is a significant economic level, he is concerned regarding heightened expectations for domestic capital expenditures, Wood observed. While the acceleration of expensing is positive, the aborted border-adjustment tax proposal would have accomplished domestic CAPEX spending on a more reliable level. Without meaningful economic growth, the tax plan is but a short-term sugar high dependent on what Wood calls a “hope” that nearly $2.5 trillion of corporate cash held offshore gets repatriated and put to work in the economy.
The devil is in the details. The correlation between favorable repatriation rate and how that money is spent is unclear. Wood notes that a positive incentive would have been to link repatriation to productive investment in the real economy, not stock buybacks or dividend increases. “Otherwise, the likelihood is that the money is spent on yet more financial engineering.”
With the number of new jobs created Friday slightly dipping – and black unemployment falling to a record low 6.8% -- Wood pointed out said before the numbers release was real labor slack due to the low participation rate. If the tax plan has a real economic impact, it might be visible through a lens of consistent wage growth and a higher participation rate.
If the timing is right, the economy might just start to pick up steam just before the election.