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Analysis | What’s Missing From Bond Markets Ahead of the CPI

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If you have an aversion to the mathematics that go with the bond market, you’re not alone. It’s complicated and counter-intuitive, based in concepts that are hard to visualize. Like all markets, it ultimately responds to supply and demand, but the forces moving investors’ demand for bonds can stretch a long way beyond macroeconomic conditions. As we brace for the another consumer price index announcment, here is a brief tour of the most contentious measures:

The term premium is the amount of extra yield you will need in order to lend over a longer period rather than a shorter one, or to quote the New York Fed’s excellent home page on this, “The compensation that investors require for bearing the risk that interest rates may change over the life of the bond.” More things can go wrong in a longer period of time, so it’s natural to regard longer-term investing as risky, but exactly how much of a premium do investors get for buying bonds for the long term?

As with another elusive but important concept, the equity risk premium (the premium you get for taking the extra risk of investing in equities rather than some risk-free investment), the term premium can only be known with certainty in hindsight. Generally, the higher the premium that investors are demanding, the greater their uncertainty about the future of the economy. A low or even negative term premium implies great confidence about the direction of the economy. 

That leads to a conundrum. Most of us can agree that the global economic outlook is more than usually uncertain. But sensible estimates of the term premium suggest that it’s historically low. This is the term premium as calculated by CrossBorder Capital Ltd.:

And this is the term premium as calculated by the New York Fed’s ACM model (short for Adrian, Crump and Moench, its inventors):

The models agree that term premia are historically low and indeed negative. CrossBorder Capital reckons the term premium is its lowest since World War II, while the the New York Fed thinks it’s slightly higher than at the height of the Covid lockdown. Either way, it’s very low. And that’s strange, as generally a fear of higher inflation (suffered by a lot of us at present) means demanding a higher term premium. You’d also expect it to be higher when the bond market is volatile, which it has been of late. So the term premium isn’t telling us what it would normally.

Instead, Mike Howell of CrossBorder summarizes the possible explanations as follows:

• There’s a big recession coming (so people are desperate for safe assets).

• There’s a shortage of collateral in the system (so people pay up for long bonds).

• There’s a lack of liquidity in the system.

Howell gives greatest weight to the last two, and suggests that regulators should be concerned about it. If there is excess demand for collateral and liquidity, that would also affect inflation-protected bonds. Inflation breakeven forecasts derived from the bond markets have been reassuringly low for most of the last two years; this might explain why, and show that breakevens aren’t sending a good signal. Beyond that, if technical factors are depressing term premiums, it could also mean that other bond market indicators of the economy cannot be trusted. Which brings us to….

My colleague Bob Burgess has a long analysis about this today that is worth reading. An inverted yield curve (in which short-term yields are higher than longer-dated bonds) is held to portend a recession. When it’s imminent, you should expect the inversion to extend along the curve, with three-month yields exceeding 10-years. On that basis, the most popular version of the curve is its most inverted since 2000, and the three-month/10-year curve is now close to inversion. So that looks terrifying:

How seriously should we take this? Again, extreme-low term premiums, for reasons that don’t seem to be tied to the economy, tend to imply that this could be a false signal. Bond yields are obeying the normal rules of supply and demand, which are usually driven by the economy — but on this occasion, maybe they aren’t sending such a clear signal. An inverted curve doesn’t cause a recession, as Burgess points out, but usually the forces that create a recession also drive an inversion. This time, maybe we can ignore the yield curve. But to quote the cliche, that does commit economic bulls to saying that it’s different this time, and those are the most dangerous words in finance. 

Quantitative Tightening (Very Very Frightening)

Interest rates take up most attention, but the decisions the Federal Reserve — and other central banks — have to make about bringing their balance sheets down to size promise to be even more important. The last time the Fed attempted quantitative tightening (QT), in 2018 and 2019, it was forced to reverse course by ructions in the repo market. And QT to date has had a tiny impact on the official size of the balance sheets of both the Fed and the European Central Bank:

Quantitative easing (QE) is widely seen as the preeminent driver of markets during the post-crisis decade. Could QT have a similar impact? Howell of CrossBorder argues that it could well. What matters is the effective balance sheet, which measures how much liquidity the Fed puts into the system. Not all possible actions change liquidity, and a raft of technical factors this year have stopped the balance sheet from contracting much so far. Once it does start to contract, however, it can be expected to have a non-linear effect on stock markets. Since the first Covid shutdown, stocks have tended to rise and fall with liquidity injections by the Fed. As this chart from CrossBorder shows, if the balance sheet is to shrink back to pre-Covid levels, the stock market could be vulnerable to fall much farther:

One powerful downward force on yields comes from the need for defined benefit pension funds to guarantee their liabilities — the pensions they have promised to their members. Higher bond yields make it cheaper to buy the annuities that back pensions, and so when yields rise high enough to allow managers to match their liabilities, they have a big incentive to buy bonds and lock in those yields while they can. That is certainly part of the reason for the heavy demand for bonds in the last few months, and at least in part explains why bond yields have fallen since June. 

As this chart from the consulting actuaries at Mercer show, the rise in yields of the last year has allowed corporate pension funds to eliminate their deficits (meaning their assets are now worth more than their liabilities) for the first time since the crash of 2008. If bond yields are at a level that allows them to guarantee that their status stays that way, they can be expected to buy more bonds:

It’s possible to lump liability-matching regulations as part of “financial repression” — measures by the government to force investors to lend to the state at uneconomically low interest rates. But a looming pension crisis has been one of the greatest fears of the last decade. If it can be averted, that would be one of the few genuinely positive financial developments of the last few months. But, yet again, liability-matching implies that the signals from the bond market don’t mean all that they usually mean.

By the time you read this, the July US inflation data should almost be here. To make sure some important second-tier data on prices and the labor market don’t get forgotten in the rush, let me point out that unit labor cost data for the second quarter show the fastest year-on-year rise since 1982. Higher wage pressure and a problem maintaining productivity will do that. That suggests that risks of a wage-price spiral remain intact.

It also suggests that price/earnings multiples for stocks are at present way over-optimistic. Over time, growth in unit labor costs and earnings multiples (shown inverted on the chart below) have had a strong inverse relationship — if labor costs are rising fast, all else equal, you should expect multiples to drop:

Why isn’t the market re-rating stocks this way? The concern about labor costs is primarily about profit margins. If companies can pass those costs on to customers in higher prices, and maintain those margins, then there’s less need to cut their valuation. And one of the most important points to emerge from the second-quarter earnings season is that companies do indeed have pricing power. They’re worried about their margins, as they should be, but so far they’re managing to maintain them. This was a pleasant surprise for analysts; revenues exceeded expectations by 2%, but profits beat forecasts by 5%.

Goldman Sachs Group Inc.’s David Kostin has published his quarterly “Beige Book” on the main points to emerge from executives’ earnings calls. Margins and pricing power were on the list. This was his summary:

Profit margins remained a top priority for company managements in 2Q. On last quarter’s earnings calls, firms highlighted rising input costs as one of the largest headwinds to their earnings. 2Q earnings calls have revealed that input costs remain a key issue for managements, particularly as economic growth has started to slow and focus has once again turned to margin stability over sales and earnings growth. In order to offset the impact of input cost pressures, firms continue to leverage pricing power. Companies have noted that consumer demand has remained robust in the face of price increases implemented over 2Q. Some companies plan on taking even further pricing action as higher commodity prices have placed further strain on margins.

All of this is great news if you’re a shareholder, and not so good if you’re a consumer or central banker hoping for lower inflation. 

Finally, the National Federation of Independent Business published its latest monthly survey of smaller businesses. The bad news is that the number complaining of rising prices and difficulty recruiting people remains near all-time highs. The good news is that these have at least been reduced from even more extreme levels earlier this year:

These are not numbers to suggest that the inflation problem is going away. They do at least suggest that the economy is now moving in the right direction. Now for some Wednesday morning excitement (or afternoon if you’re in Europe, or a nightcap for those in Asia).

If you’re looking for a culprit for stock markets’ volatility in recent years, perhaps blame tech stocks. The sector has an unparalleled impact on the overall performance of US equities. If nearly 100 years of history are any guide, the S&P 500 only outperforms when the tech sector does so as well. The line graph by the Leuthold Group below shows the relative total return back to 1926 for the the sector:

The letters, as seen above, highlight major periods when the sector outperformed…

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