Yield Curve Control (YCC) is a central bank tool that the Bank of Japan (BoJ) has implemented since 2016. This is around the time I first got very concerned that fixed income markets would not protect investor portfolios due to the anchoring effect it would cause.
In the previous few years, we had seen the European Central Bank (ECB) move to negative overnight rates while the Bank of Canada (BoC) and Federal Reserve (Fed) had overnight rates at zero. Around this time, we saw as much as US$17 trillion of global interest rates turn negative. Last week, the BOJ adjusted their YCC anchor. And while BoJ Governor Kazuo Ueda has not abandoned easy money policies, they are the last central bank to come off zero rates. The policy change is meaningful from a flow of funds perspective. Immediately, bond markets all over the world moved to higher yields. The higher yields get the lower valuations should be for most asset markets like equities.
Last week, Federal Reserve Chair Jerome Powell suggested there is likely more work to do. Over the weekend, Neil Kashkari, president of the Minneapolis Fed, said, “I personally don’t think that’s realistic, that we’re going to end this inflation cycle with no cost to the labour market.”
U.S. unemployment continues to hover at a historically low 3.6 per cent, though the rate may tick up as high as four per cent in coming months, he said.
“That in my book would still be a soft landing.”
The Fed is now trying to shape the narrative that a recession will be mild and that it would be considered a soft landing. Powell said during his press conference that Fed staffers no longer forecasting a recession. The market has, in part, been very resilient as it believes that the fastest rate hike cycle in history will end without a recession. To us, this seems extremely unlikely, but we tend to be more realistic than hopeful when making forecasts about markets. Wall Street and elected officials will tend to be overly optimistic when making forward looking statements.
If the long-term bond rate anchor has been lifted by the BoJ, the massive U.S. deficits, along with quantitative tightening (shrinking the Fed’s and other central bank balance sheets) could have a negative influence depending on how it will be financed. That job is done by Janet Yellen and the U.S. Treasury. We find out this week how that will be financed at 8:30 am on Aug. 2 at the Quarterly Refunding Announcement (QRA).
One of the best Treasury analysts I know is Andy Constan of Damped Springs Advisors. He believes that the Treasury will need to normalize their issuance mix in the coming quarters. Funding the U.S. government is at the core of understanding global liquidity and interest rate markets. Since QT started in Q3 2022, the amount of debt issuance has exploded, and longer-term interest rates started to rise as the U.S. Federal Open Market Committee (FOMC) fell behind the inflation curve. In the most recent quarter, after the U.S. debt ceiling was raised, the vast majority of issuance came from T-Bills. Historically, the mix of U.S. debt is about 80 per cent bonds (coupons) and 20 per cent bills (discount). Over the coming quarters, if Yellen moves back to the long-term norms, the amount of coupon debt will most likely push rates higher. The demand for coupon debt increases with recession risk and decreases with inflation risk. What a conundrum indeed.
It is clear that the massive deficit spending of the U.S. government is a 2024 election issue. The Democrats need a strong economy, the GOP would prefer a recession to be able to take back the White House. With Congress now in control of the GOP (the folks that write the cheque), you can bet the lack of a U.S. budget deal will negatively impact the economy in 2024 when it might need the stimulus. Combine rising yields with less spending and a soft-landing outcome becomes an increasing challenge.
We are very cautious on asset markets. The general sentiment in equity markets is bullish. Artificial Intelligence and the soft-landing narrative with falling inflation is clearly driving the fear of missing out risk appetite. Earnings season has seen a slight increase to forward based earnings. Our models and liquidity outlook suggests a higher degree of caution. It’s tough being a contrarian in this market to be sure.
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