Time to buy bonds?

So says Jeffries. My own view is that oil has likely peaked for the cycle already as China and India extract Russian oil and sanctions steer clear of energy. If you subscribe to it, my base case of the five shocks of European war and energy, Chinese property and OMICRON,  and US rates driving global recession commencing H2, 2022 makes bonds attractive at current levels.

Quantitative tightening is now officially on the agenda, as reflected in the release of the Fed minutes on Wednesday and pending FedVice Chair Lael Brainard’s hawkish speech on Tuesday where she endorsed balance sheet contraction and stated that the “paramount” objective was to bring inflation down. This is in stark contrast to her doveish commentary for most of last year where her prime focus was “inclusive” employment. As a result, a 50bp hike in the federal funds rate now looks a done deal in May while the quanto tightening details imply a reduction in the Fed balance sheet by an annualised US$1.14tn from the current US$8.94tn.

The Fed minutes revealed a plan to reduce the size of the Fed balance sheet with a monthly cap of US$95bn on runoff (US$60bn for Treasuries and US$35bn for agency MBS) and a three-month phase-in period. The FOMC participants also agreed that for the months where Treasury bond runoff falls below the cap, the Fed will top that off by redeeming its holdings of Treasury bills via outright asset sales. The announcement of quanto tightening has led to a further sell-off in the Treasury bond market. The 10-year Treasury bond yield rose from 2.55% on Tuesday to an intraday high of 2.66% on Wednesday. This is not surprising in the first instance since balance sheet reduction implies the Fed selling Treasury bonds.

But, empirical experience shows that the impact on yields is the opposite of what central banks argue. That is that quanto easing has in practice been bearish for Treasury bonds and quanto tightening has been bullish because it amounts to an effective form of monetary tightening (see Exhibit 1).

It is also worth noting that the ten-year Treasury bond yield is not so far off testing the long-term trend line in place since the bull market in Treasury bonds begun in 1981, which is currently at around 2.8% (see Exhibit 4). This has often been described as the most important chart in the world since a break of it would amount to confirmation of the end of the disinflationary era of the past 40 years. Meanwhile if the Fed’s seeming adoption of the most ambitious attempt at balance sheet reduction in the modern era is a reason to think about buying Treasury bonds, it also might be asked what are the sort of dynamics that could cause a convincing breaking of that trend line in terms of a move to higher yields.

GREED & fear was asked such a question in one meeting this week. And one such catalyst could be a significant surge in the oil price, say to the US$150/bbl level. If the traditional correlation between the oil price and inflation expectations remains intact, this would cause the five-year five-year forward inflation expectation rate to surge well beyond the 2.5% level, which to GREED & fear is a sign that long-term inflation expectations are becoming destabilised or “unanchored” to use central bank jargon (see Exhibit 5).

If this indeed proves to be the case then the new hawkish Fed should respond to such a signal by more tightening, whereas for most of the past 40 years oil price spikes were seen as deflationary because they reduced disposable income. But now, with wages rising and the labour market perceived to be overheating, there is a better case that higher oil prices will drive demand for higher wages in a classic 1970s-style wage-price spiral. Certainly, the latest wage data shows that wage growth remains strongest at the low end of the labour market as highlighted by Jefferies’ US chief economistAnetaMarkowskain her report last Friday (see March Employment: Payrolls Continue to Climb on Trend, Wage Growth Rebounds, No Change for the Fed, 1 April 2022). Thus, average hourly earnings of private production and non-supervisory workers rose by 6.7%YoY in March, compared with 5.6% for total private wages (see Exhibit 6). While average hourly earnings for the leisure and hospitality sector rose by 11.8% YoY in March.

Meanwhile, in a 1970s flashback, GREED & fear heard this week that New York doormen are threatening to go on strike.

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