TSP Smart: Stumbling into a New Cycle

By Doug Noland on April 16, 2022

Fed suppresses interest rates for 12 years not realizing they were distorting inflation expectation indicators too.

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This implies a major cycle inflection point for the bond market, now faced both with a secular upturn in inflation and diminished QE prospects. And a secular jump in Treasury yields would demand a long overdue downward valuation adjustment for stocks, corporate Credit and other financial assets.

Eventually, the backdrop is viewed more in terms of a stagnant or shrinking pie – with a newfound zero-sum game calculus. The downside of the cycle heralds a period of fragmentation, animus and conflict. From this perspective, the world appears well into the transition to a perilous down cycle dynamic.

In particular, there is post-bubble vulnerability for scores – literally thousands – of negative cash-flow companies and enterprises. In this regard, I anticipate a difficult and protracted structural adjustment ahead. And when I look at our nation today, I dread how this adjustment will intensify social and political strife.

Transitioning to a New Cycle

by Doug Noland

Something snapped. Ten-year Treasury yields jumped another 12 bps this week, with a two-week gain of 44 bps. At 2.83%, 10-year yields ended the week at the high since December 2018. Thirty-year Treasuries yields surged 20 bps this week (2-wk gain 48bps) to a three-year high 2.92%. Benchmark MBS yields rose another eight bps this week to 3.98%, with a stunning 191 bps y-t-d spike. Thirty-year mortgage borrowing rates jumped 28 bps this week to 5% for the first time since February 2011, having jumped 189 bps so far this year.

The Bloomberg Commodities Index jumped 4.8% this week, boosting y-t-d gains to 33.5%. Crude’s 8.8% weekly surge pushed 2022 gains to 42%. Gasoline jumped 8.0% (up 52% y-t-d), and Natural Gas spiked 16% (up 96% y-t-d). Wheat and Corn gained 4.4% and 3.0%, with y-t-d gains of 43% and 32%. As for 2022 gains, Nickel is up 60%, Cotton 26%, soybeans 27%, rubber 28% and zinc 25%.

A month back, I titled a CBB, “Inklings of Secular Change.” It increasingly appears the world has reached a critical historic juncture – the transition away from an unparalleled market, financial and economic up-cycle. While such a momentous development is usually recognized only in hindsight, there is today overwhelming fundamental and market support for The New Cycle Thesis.

For much too long, global policymakers pushed stimulus measures to precarious extremes, monetary inflation that extended the cycle – but at great cost. Some of these costs are being revealed. War rages in Ukraine with no end in sight. Meanwhile, March Consumer Prices were reported up 8.5% y-o-y, the strongest inflation since 1981. And each passing week it seems the world is more deeply divided, with the fraught U.S./China relationship at risk of dissolution.

April 13 – Bloomberg (Christopher Condon and Eric Martin): “Treasury Secretary Janet Yellen… delivered a pointed warning to China on its alignment with Russia, suggesting potential economic consequences from the international community depending on how it approaches President Vladimir Putin’s invasion of Ukraine. ‘China has recently affirmed a special relationship with Russia,’ Yellen said… ‘I fervently hope that China will make something positive of this relationship and help to end this war.’ Yellen used the speech… to lay out the contours of a revitalized international financial and economic architecture. While she said she hopes to avoid a ‘bipolar’ split between U.S.- and China-led systems, her remarks may deepen bilateral tensions. In some of her sharpest comments on China since taking office, the Treasury chief warned that ‘going forward, it will be increasingly difficult to separate economic issues from broader considerations of national interest, including national security.’”

The Bubble analytical framework offers valuable insight. During the up-cycle boom, the economic pie is perceived as robust and expansive. Cooperation, integration and strong alliances are viewed as beneficial – both individually and collectively. But as the cycle ages, strains mount and insecurity increasingly takes hold. Eventually, the backdrop is viewed more in terms of a stagnant or shrinking pie – with a newfound zero-sum game calculus. The downside of the cycle heralds a period of fragmentation, animus and conflict. From this perspective, the world appears well into the transition to a perilous down cycle dynamic.

We can’t overstate the significance and far-reaching ramifications of this secular shift away from the promise and assurances advanced over a multi-decade up-cycle to today’s ominous down-cycle uncertainties.

Ten-year Treasury yields have surged 85 bps since the February 24th invasion. German bund yields jumped from 17 bps to an almost seven-year high 0.84%. Since the start of war, yields have increased 77 bps in Portugal, 67 bps in Italy, 67 bps in France, and 44 bps in the UK. Yields rose 79 bps in Canada, 70 bps in Australia, 74 bps in South Korea, and 62 bps in New Zealand.

EM yield moves are even more dramatic. Since the invasion, 10-year yields have increased 198 bps in Poland, 164 bps in Hungary, 108 bps in the Czech Republic, 101 bps in Romania, 86 bps in Croatia and 86 bps in Slovenia. Major bond market adjustment has not been limited to Eastern Europe. Yields are up 130 bps in Peru, 98 bps in Mexico, and 74 bps in Brazil.

While Treasury yields are up sharply, it’s worth noting that the last time the U.S. experienced 8.5% y-o-y CPI 10-year yields were at 14%. The yield curve has been gyrating. The 2-/10-yr Treasury yield spread inverted to negative eight bps on April 1st. The 2-/10-year spread was about zero as Lael Brainard dropped her “Fed to Shrink Balance Sheet at Rapid Pace as Soon as May” bomb (front-running by a day FOMC minutes detailing plans for $95bn monthly QT). The curve has steeped 37 bps in nine sessions. Analysts two weeks ago pointed to the inverted curve as foreshadowing recession. There’s now a lot of head scratching.

This beckons for some analytical nuance. When we discuss traditional analysis and market relationships, it’s important to appreciate that so much changed as QE evolved into a primary monetary management tool. How could 10-year yields remain so low in the face of surging inflation and the onset of what is anticipated to be the most aggressive tightening cycle in 28 years? Because the marketplace anticipates tightening measures will prove short-lived. The Fed will surely be forced into additional bond purchases – another round of endless QE.

The bond market’s relative disregard for inflation risk recalls the period heading into the 2008 crisis – a dynamic that worked to prolong excess and deepen the unavoidable crisis. Today’s relatively flat yield curve is indicative of dysfunctional markets, distorted by years of Fed intervention and monetary inflation – with the recent inversion not so much a predictor of recession, but more a reflection of bubble fragilities and the inevitability of additional crisis measures.

Low long-term yields and expectations of Fed intervention have provided critical support for the stock market bubble. Stock and bond markets have been unable to adequately adjust to the rapidly deteriorating fundamental backdrop, and I would contend that resulting wealth effects and loose financial conditions have worked to sustain problematic inflationary dynamics. And the longer bonds and stocks downplay ramifications for an aggressive tightening cycle, the greater the pressure on the Fed to talk hawkish rate hikes and balance sheet liquidation. It appears the bond market adjustment to the New Cycle has commenced.

Even the diehard FOMC doves have found religion, apparently coming to the realization that inflation hurts most those that can least afford it. It’s late in the game for such an epiphany. A cycle of Federal Reserve monetary mismanagement has dangerously weakened the foundations of economic, financial, social and geopolitical stability.

When contemplating secular change, we should think in terms of an extended period of instability. The war has caused a spike in already elevated food prices, with a significant risk of future global grain and food shortfalls. This is a backdrop conducive to social and political instability, with recent unrest in Peru and Sri Lanka surely just the beginning.

The war also further stresses global supply chains. Russia, of course, is a major exporter of energy, materials and commodities. The onset of war saw dislocations in many commodity markets, most notably nickel with its spectacular short squeeze, margin calls and dislocation.

The war will likely mark a secular inflection point for commodities trading, both in spot and derivatives markets. Producers will approach derivative hedging strategies more cautiously, fearing big squeezes and onerous margin calls. Derivative dealers will back away from unstable and dysfunctional markets, while bankers will tighten standards for loans and backup credit facilities. It all points to less liquidity and more price volatility.

Russia will likely restrict the sale of key commodities to the West, leading to price spikes and shortages. There is risk that China eventually follows a similar course. I anticipate households, companies, and countries all moving to build inventories of key resources – only worsening shortages and supply chain issues. Panic buying of many things is a distinct possibility.

It’s worth noting last week’s release of February Consumer Credit data. More than doubling estimates, households expanded non-mortgage borrowings by a record $41.8 billion. For perspective, during the decade 2010 through 2019, Consumer Credit growth averaged less than $14 billion monthly. This is an example of how inflation spurs self-reinforcing credit growth – as we take out larger loans to purchase higher priced vehicles, appliances, home remodels and such, while putting the higher cost of filling gas tanks and shopping carts on credit cards. Recall that Q4 mortgage credit growth was the strongest since 2007 – again highlighting the dynamic of inflating prices, spurring only greater credit expansion. Moreover, rising debt service and huge federal deficits will continue to fan inflationary fires.

We are witnessing the onset of a New Cycle, with inflationary dynamics reminiscent of the seventies and eighties. And the Fed today faces one momentous challenge, as it attempts to get inflation under control. This will prove nothing short of a secular shift in monetary management.

The previous cycle’s subdued consumer price inflation – empowered a Federal Reserve policy regime focused on championing the asset markets – as the key mechanism for economic advancement and prosperity. “Baby step” rate increases were signaled well in advance and implemented gradually, all to ensure that booming securities markets avoided instability. And it went without saying that any so-called “tightening” would be quickly reversed in the event of market anxiety. Importantly, a powerful policymaking regime dynamic took control: no longer was it even necessary for financial conditions to tighten during so-called “tightening” cycles.

And securities markets grew to revolve around loose conditions and the “Fed put” – as confidence in the Fed’s willingness to do whatever it takes to bolster the markets incentivized speculation, leverage and risk-taking more generally. Cash was made trash, with savers then plowing Trillions into the securities markets, most notably in perceived liquid and “money-like” ETF shares.

For the New Cycle of monetary management, the “Fed put” will surely not be completely discarded. But the FOMC will now be forced to think hard before unleashing additional inflationary fuel. Measures to support the markets will not come as quickly – and I expect future QE to at least initially be doled out in moderation. This implies a major shift in the Fed’s willingness, capacity and tactics for backstopping the markets.

A revamped policy doctrine with less predictable and generous central bank market support will require an adjustment in securities and derivatives pricing. Financial assets become riskier, implying greater risk premiums and lower valuations. Derivative markets must also adjust to new realities. If the Fed no longer actively controls “the weather”, the previous cycle’s boom in cheap flood insurance is no longer viable. Said differently, the assumption of liquid and continuous markets – having defined contemporary “dynamically/delta hedged” derivatives markets over the boom cycle – becomes difficult to rationalize.

Selling derivative insurance has become a riskier proposition. This suggests a secular shift to more expensive derivatives protection – with higher-cost market insurance, on the margin, providing less support for risk-taking and speculative excess. I believe the popular strategy of just buying cheap hedges and sticking with risky portfolios through difficult market environments was anomalous to the previous cycle.

Commodities performance provides overwhelming support for the thesis of a new cycle of hard asset outperformance versus financial assets. Interestingly, huge commodities gains unfolded during a period of relative dollar strength. The dollar index is up 5% this year. Moreover, even the industrial commodities have been robust in the face of faltering China. Some commodities are exposed to weakening Chinese demand dynamics. But this risk is at least somewhat offset by Russian sanctions, supply constraints, and the impetus to build rainy day stockpiles.

There has been of late insightful discussion of the potential negative impact sanctions and the bi-polar “iron curtain” new world order might have on the dollar as the world’s reserve currency. Some of this analysis resonates.

But there’s another aspect of dollar vulnerability that goes unrecognized. The previous cycle of well-contained consumer price inflation – that emboldened the Fed’s securities and derivatives market focus – was instrumental in underpinning the dollar. This experimental monetary regime bolstered our currency even in the face of massive monetary inflation, persistently huge trade deficits and deep structural impairment.

Why would the world not recycle excess dollar balances back into U.S. securities markets, confident that the Fed was doing “whatever it takes” to ensure those securities rise in value? Traditional currency fundamentals – prudent monetary and fiscal policies, stable money, a favorable current account position, and sound financial and economic structures – no longer mattered – so long as Federal Reserve policy focus was directed at sustaining booming asset markets.

The world is now experiencing momentous change, with overwhelming evidence supporting the view of a Transition to a New Cycle. Federal Reserve focus has begun the shift to consumer price inflation, leaving the status of the Fed’s market backstop a major open question. Going forward, expect the dollar to be increasingly vulnerable to waning confidence in the Fed’s capacity to underpin the markets. This raises the possibility the next serious bout of de-risking/deleveraging being will be accompanied by destabilizing currency market volatility. This is a looming risk for a financial world dominated by leveraged speculation.

And a final thought on the New Market Cycle. The unfolding crisis of confidence in monetary management and financial assets, more generally, has momentous ramifications. As Hard Assets outperform financial assets, liquidity will now gravitate to real things, working to underpin inflationary pressures even as growth weakens. This will keep pressure on the Fed, with higher cash rates reducing the appeal of risk assets. Moreover, these new inflation dynamics dramatically alter the risk versus reward profile for QE and monetary stimulus more generally. Fed bond purchases will create additional liquidity now likely to gravitate to – and reinforce – commodities and general price inflation.

If the view of a secular shift in inflation dynamics is correct, we should expect a new paradigm of tighter monetary policy and tighter financial conditions more generally. This will be highly disruptive to economic and financial structures that overindulged in ultra-loose finance over the previous long cycle. In particular, there is post-bubble vulnerability for scores – literally thousands – of negative cash-flow companies and enterprises. In this regard, I anticipate a difficult and protracted structural adjustment ahead. And when I look at our nation today, I dread how this adjustment will intensify social and political strife.

Original Post 16 April 2022

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