Taper tantrum 2.0 begins as markets catch hysteria virus

What a business cycle this is. Juiced by virus amphetamines it is moving extraordinarily fast. Last year we had the crash down, the crash up, a depression, thumping stimulus and K-shaped recovery, a gold boom and bust on debasement, growth stock bubble and now bust plus value rotation, an alleged commodity super-cycle, and now, one year on, we are into the inflation panic and taper tantrum as fears of overheating strike.

This is literally a full ten-year business cycle in one year!

Overnight we saw markets gyrate as taper tantrum 2.0 strikes. DXY fell then rose:

The Australian dollar pumped and dumped:

EMFX was put to the sword:

Oil and gold are deadly enemies:

Base metals also pumped and dumped:

Big miners were mixed:

EM stocks look very toppy:

Though we will need to see more stress than this in high yield if this sell-off is to continue:

Treasuries were belted:

Aussie, Aussie, Aussie. Not!

It’s proving too much for the tech bubble:

The bond sell panic that began yesterday in Australia spread to the US as a 7-year auction nearly failed. Bloomberg sums it up neatly:

There comes a point in any big selloff in Treasury bonds when the move becomes so pronounced that it starts to feed on itself. Increases in yields force a crucial group of investors to sell Treasuries, which in turn leads to further increases in yields. Two months into this rout, that moment appears to have arrived, and it’s beginning to send shudders throughout all corners of U.S. financial markets.

The forced sellers are investors in the $7 trillion mortgage-backed bond market. Their problem is that when Treasury yields — which strongly influence home-loan rates — suddenly rise sharply, many Americans lose interest in refinancing their old mortgages. A reduced stream of refinancings means mortgage-bond investors are left waiting for longer to collect payments on their investments. The longer the wait, the more financial pain they feel as they watch market rates climb higher without being able to take advantage of them.

Their answer: unload the Treasury bonds they hold with long maturities or adjust derivatives positions — a phenomenon known as convexity hedging — to compensate for the unexpected jump in duration on their mortgage portfolios. The extra selling just as the market is already weakening has a history of exacerbating upward moves in Treasury yields — including during major “convexity events” in 1994 and 2003.

Where to from here? The coming inflation spike is not what it is being made out to be. It will be a temporary catch-up spike as vaccines take effect:

Inflation returning to trend

PIMCO captures our view:

“There is a material risk for the bond market of an inflation head fake,” Ivascyn told the Financial Times.

“This could be a powerful recovery and we have never gone from locking down an economy to opening it back up with this amount of stimulus.” Pimco expects any inflation pick-up will prove temporary, but “the bond market may not come to that conclusion in the near term”, Ivascyn said.

Inflation will remain contained because of long-established trends such as technological innovation cutting costs and the weakness of organised labour, Pimco has argued. Slack will also linger in the labour market due to high unemployment, Ivascyn said. “We still see powerful disinflationary trends. After an initial recovery [from the pandemic] there is likely a world of excess capacity,” he said.

That said, while the short-term spike approaches markets can fantasise darkly, notably Albert Edwards at Societe General:

“if bond yields continue to rise and there is a smooth rotation out of growth and defensive stocks into value and cyclical stocks, the Fed will remain sanguine.” But the risk is growing that “with so many bubbles blown by the Fed something will burst soon. And despite the widespread certainty that the Fed can micro-manage the equity market, and levitate it at will, the real shocker would be if the Fed lost control in any impending equity riot.

…a yield gap of 2% was the point at which the tech sector started to lead the overall equity market lower.

…the real risk is that further monetary concessions won’t appease the mob and Fed control is lost. For as Jeremy Grantham reminded us recently, this bubble has now become as big as anything in history as will be the inevitable denouement.”

I do not expect the Fed to lose control. The idea that it ever had complete control is a fantasy. And that may now die. The market will still be the market. As it prices for short-term inflation, we’re getting the usual unwind of robotic positions that have gotten too far onto one side of the boat. Via robot specialist, Nomura:

…selling of global government bond futures by trend-following CTAs has rightfully been cited as one cause of the steep rise in yields…CTAs’ selling of bond futures has gotten so relentless as to look a little unnatural. Why would this be?

…whatever the underlying forces, the balance of supply and demand among major players in the UST market is tilted far enough to the selling side that it has become difficult to ignore the possibility of a rise in the 10yr UST yield to above 1.5%…the US equity market, no longer able to endure the strain of rising yields, could lose its composure at that point.

This is another market clearout on amphetamines exacerbating the underlying needed repricing of yields for the recovery. At a certain point, a new equilibrium will be reached in which combined bond and equity selling hits the growth outlook sufficiently that it calms down and both become buys.

David Llewellyn-Smith
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