In my last article I wrote about selling off some gold and going short bonds. The trade has worked well so far and as I expected, CPI and some underlying inflation signals have helped to move the Fed's rate hike expectations. PCE on the other hand came in pretty tame and is a current challenge to my thesis. When I wrote the article, the 10 year was at 2.04% and is now trading at 2.33% and has broken out of its down trend from March. To break the real, long term trend, the 10 year will have to be another 30 bps higher in the future. You can see the breakout below. This move has been a nice shorter term breakout but has not yet made a new high so is nothing to be too excited about yet. I personally believe it is just getting started and has the potential to at least test the long term trendline, which would be a significant macro event for not just the US but the global economy. I wanted to write an update to express my view and to entertain the debate about whether quantitative tightening (QT) will move yields higher or lower.
A new popular view is that QT will push yields down because QE pushed yields higher during actual operations. First of all, none of us know which will happen, but my view is that no - rates will in fact rise.
The argument I have read on Bloomberg and elsewhere for why rates will fall is simply that they moved higher during QE. Simple view but it could be correct. A lot of ink has been spilled on this but I will focus on one Bloomberg piece. Below is a great chart from the article - and to the credit of the people who have this view - I bet most people do not realize rates rose during QE. I'm sure some people think the Fed is getting too tight and we will be easing really soon and so you better just get ahead of that and bet on lower rates. Makes sense and we all know that eventually the Fed will get tight enough to burst this epic asset price bubble. The important question in my mind is will the Fed be too tight for fun or to chase higher inflation. This is where I think I see it differently. My view is that the Fed will go from ahead of the curve to behind and in a time-frame that will surprise most market participants. The economy is extremely leveraged to the new normal of no interest rates, no inflation, and no risk - so if I am right, the road will be very bumpy. I think some folks calling for lower rates despite a shrinking balance sheet are just tired of calling for rates to rise every year and being dead wrong. Even if you had been on Wall Street for 30 years and were nearing retirement and had called for rates to rise every year - you would have been an idiot for an entire generation. Pretty easy to see QT as just another boy crying wolf, considering almost zero investors operating in markets today even know what inflation or a secular rise in rates even looks or feels like. Hell 99% of portfolios in America are built on the view that bonds are a perfect hedge to equities despite that only being true since Elvis died essentially. Has anyone even considered what happens to portfolios if that temporary relationship changes? Seems not.
So yields did go up during QE which is odd right - the Fed was buying bonds hand over fist, why in the hell did yields go up? Well in my mind it is because we all thought QE would actually cause inflation and maybe even some damn growth. I am an Austrian so I of course thought I'd use dollars as wallpaper and I was dead wrong. It took an interview with a guy pointing out the accounting realities of QE for me to realize it would not be inflationary any time soon, if ever. So whenever market participants saw QE as certain to ignite inflation, if not really high inflation, of course rates went up. But each time the training wheels came off our little bike just fell into the ditch and yields went back down. Turns out printing money and stashing it in reserves in exchange for bonds does just about nothing for Joe Sixpack and the real economy. Businesses have not trusted the real economy enough to expand and hire etc. Well now all of a sudden that may just be changing as we abandon failed ZIRP/QE and start offering incentives to save again. Soft data gets made fun of but there are some really excited businesses and CAPEX is starting to move, especially in smaller firms that employ a ton of people in America. Maybe it is just noise, but if it isn't - inflation may get real for a bit.
The thing is, I think most people in markets now realize that QE does not work. At least I hope so because Japan has been doing QE since Moby Dick was a minnow and inflation and growth are still a fantasy there. Maybe just maybe offering an incentive for saving could get people to save and invest and get the economy moving? QE and ZIRP certainly didn't, other than "investing" in financial engineering.
I think we are going to get some cyclical inflation due to tighter labor, imported inflation, higher commodities etc. We will at least test the trendline on 10 yr yields I have drawn from the early 90s (goes back to the 80s as we know) which will be the battle for how real this rate rise is. Right now I am just not sure, but for some reason I think it is possible to see rates breakout and even settle above the 3% area that was rejected in late '13 / early '14. I think half of the reason I see this as a real possibility is because nobody thinks it is possible anymore.
A lot of smart people would simply say okay fine - rates can go to 2.75% or 3% but then that breaks everything and the Fed just prints a ton of money and buys all of the bonds and we are back at 2%. Well, if we get more inflation than anyone anticipates that will be difficult to do. If you can do math you know that the Fed eventually has to let inflation run really hot unless we pursue some sort of honest default on our debt and obligations. History teaches us which is more likely. The manner in which President Trump packs the Fed will play a big role here and how he wants the Fed to proceed when inflation starts to come in hot. When I imagine hot inflation, all I can picture in my mind is a bunch of doubters calling it temporary - in the media, on Wall Street, and at the Fed. Not to mention moving the goalposts and making excuses because we have been below "target" for a while. Longer term I have no idea what happens with inflation and rates, but for the next year or so I think both may surprise to the upside.
Below is a look at rates on the ten year and the trendline I drew dating back to 1994. Something very notable on this chart is that the dot.com bust and the GFC both occurred about 6 months after the trendline was tested. This does not mean a fresh retest of the line will bring on a crash of course, but I will certainly be looking for cracks in equities that much harder during that time-frame. You can see for yourself on this chart where the trendline is and the tests in 2000 and 2007. I provided a zoomed in view of the recent breakout of what looks like a bull flag and rates that may be headed to test this line again. I am still very focused on the dollar but for me right now, this is the center of the financial universe and I will be watching closely. I am short bond futures (the long end making less money of course) and I am long USD/JPY trying to capitalize on this trade. I will trade around some technical areas and get out when we test the trendline that is as old as I am to see what happens and evaluate the macro picture when it happens (if it does.) I hope this article made you think or inspired you to educate me on why I am wrong or added a new insight.