Have bond traders predicted the future

Fall fell, stocks rose.  Stocks rose yesterday as investors expressed their relief that the Fed served up no negative surprises on Wednesday.  Bond traders pressured longer maturity rates as they set their sights on inflation.

N O T E W O R T H Y

On second thought.  There was a bit of head scratching going on after Wednesday’s market close. The Fed had all but guaranteed that it could start tapering bond purchases as early as November and bring them down to 0 by the middle of next year.  The very same Fed also leaned closer to raising interest rates at least once by the end of 2020.  In most cases, those would have been considered a signal to sell stocks AND bonds.  On the contrary, stocks rose along with bonds after the announcement.  Ok, stocks have a mind of their own, but bonds are supposed to be the “adult in the room.”  Bond traders are practical, tied closely to unemotional institutions, and very much driven by economic performance.  Yields actually went down in the wake of the announcement.  Interesting, surprising, and confusing.  Hence, head scratching.

After sleeping on it however, bond traders came in with a different attitude.  First, The Bank of England, the UK’s version of the Fed announced its policy yesterday, and it read like a slightly more aggressive version of the US Fed’s policy.  The BOE was set to taper its pandemic era bond purchases and begin to hike key lending rates as soon as the first quarter of 2022.  The BOE further, raised its near term inflation forecasts.  The news sparked a selloff in UK Gilts, causing yields to climb.  Gilts are the UK’s equivalent to Treasuries. The early morning Gilt selloff prompted a selloff in longer maturity US Treasuries, which continued throughout the longer US session, leaving the 10-year treasury yield +13 basis higher than the previous day’s close. The rise in longer term treasury yields also caused a recognizable, but not tremendous, steepening of the yield curve.  Ok, so why all the confusion? 

Historically, bond yields rise and yield curves steepen when economies run hot enough to prompt the Fed to tighten its policy.  This is largely due to inflation expectations which rise in a rapidly expanding economy. In late 2020, the economy was recovering quickly and inflation began to rise.  As predicted, longer maturity yields began to rise and the yield curve began to steepen.  Atypically however, longer maturity yields began to fall in late spring of this year.  The reason: the Delta variant surge. Economists began ratcheting down the economic growth forecast and wondering if the economic recovery had stalled. Simultaneously, the inflation situation worsened, which under normal circumstances would cause yields to go higher… but they did just the opposite.  On Wednesday, many capital markets traders were focused on the taper timeline and the dot plots.  No shockers there.  As reported here yesterday, the Fed also released its economic forecast which did not get much coverage.  That forecast showed that, since its last forecast in June, the Fed had raised its inflation expectations and cut back its economic growth projections.  Cutting back on bond purchases was simply not enough to cause bond traders to adjust their positions, but higher inflation projections and slower growth… well you can only fight the math for so long.  You see, inflation eats into the fixed income coupon payments received by bond holders.  Higher inflation means lower real yield, which can only be adjusted by higher nominal yields… selling bonds. We saw that yesterday, as longer maturity bonds sold off.  What about stocks, why did they continue to rally yesterday?  As mentioned in my morning note yesterday, knowing is everything for stocks.  Just having answers on the timeline for tapering and hikes helped sustain a relief rally. Or perhaps stock traders looked more carefully at the Fed’s projections and noticed that member’s revised their economic growth projections for 2022 and 2023 upward.  Inflation expectations for those years show that the Fed expects these current levels to recede to target levels.  Remember, stocks factor in future expectations.  Bond traders will be rethinking their thesis once again today.  Ten-year yields are still almost 30 basis points lower than March’s highs. Keep scratching.

THE MARKETS

Stocks extended their relief rally yesterday despite a series of weaker economic releases in the morning… all eyes were on rising bond yields.  The S&P500 rose by +1.21%, the Dow Jones Industrial Average climbed by +1.48%, the Nasdaq Composite Index advanced by +1.04%, and the Russell 2000 Index traded up by +1.82%.  Bonds fell and 10 year treasury yields tacked on +13 basis points to 1.43%.  Cryptos rallied by +3.53% and bitcoin climbed by +2.90%.  WHILE YOU SLEPT, Chinese authorities made all crypto transactions illegal in China.  The news caused a crypto sell off and Bitcoin is currently down by -6.94%.

NXT UP

– New Home Sales (August) may have risen by +1.0 for a second straight month.

– Today’s Fed speakers include Mester, Clarida, Bowman, George, and Chairman Powell.

– More earnings will trickle in next week in addition to Durable Goods Orders, regional Fed reports, more housing numbers, Conference Board Consumer Confidence, GDP, PCE Deflators, and University of Michigan Sentiment.  Yeah, that’s a lot, so check back in on Monday for calendars and details.