Most of us are familiar with QE but what is QT? When the Fed reduces its balance sheet it is known as quantitative tightening, the flipside of quantitative easing. The US Federal Reserve at its December FOMC put the world on notice that tighter financial conditions are ahead. What does it mean? The possible Bifurcations would make Mandelbrot wince.
Firstly, the bond market has a lot more work as the task of financing governments gets more difficult without central banks buying. It is important to note the effect is global, not just the US.
We have been experiencing shrinking quantitative easing by central banks. Think of that Central Bank buying as buying by price-insensitive buyers. While we see many look back at the last tightening cycle for clarity it is a different beast this time. The Fed the last time commenced balance sheet reduction (or quantitative tightening) only once the cash rate tightening cycle was well advanced. This caused much upheaval as it was overly restrictive. This time around the Fed appears to be acting more contritely by reducing the balance sheet beforehand.
The bond market has reacted as one might expect. The US 10-year yield had the largest first day jump since 2009 on the first day of 2022 and hit 1.80% at one point. 10-year notes have sold-off 0.45 per cent since mid-December, generating a loss of over 4 per cent. US real yields have weakened 0.22 per cent in that time. No surprises here with rampant inflation. This move implies half of the weakness in nominal bonds is related to rising inflation.
US Producer price inflation continues elevated, a long way from the Central Bank transitory mantra. Annual PPI rose to 9.7% in December. This was the largest increase since data were first calculated in December 2009. The 0.2% month-over-month rise was less than a consensus 0.4% due to the sharp drop in oil prices which has since reversed in January as has natural gas.
US CPI in December rose 0.5% m/m in December (consensus +0.4%). Core CPI rose 0.6% (consensus +0.5%). On a year-over-year basis, total CPI is up 7.0% (versus 6.8% in November) and core CPI is up 5.5% (versus 4.9% November). Inflation remains persistently high as Central Bankers keep trying to reassure us that soaring inflation will come under control.
Here’s a thought to shake bond traders, since those reports oil prices have risen 16 per cent. Meaning not all of that December headline inflation at 7 per cent year-on-year is covered,
So what does the market say? Four interest rate rises are factored into the US market over 2022, yet the implied inflation rates point to the current inflation pulse passing.
U.S. Treasuries finished the second week of 2022 with sharp losses across the curve. The 2-yr yield, which tracks expectations for the fed funds rate, settled on its low, lifting its yield to its highest level since February 2020 as speculation about a faster rate hike pace boils in the background. This week’s underperformance in shorter tenors caused a nine-basis point flattening in the 2s10s spread to 81 bps. The 10-year yield stood at 1.76% on Friday, after topping 1.8% earlier in the week.
CME FedWatch Tool shows the probability for a rate hike in March increased to 79.0% Friday, versus 75.9% a week ago and 35.8% one month ago.
Inflation Linked Bonds
A key input into the value of inflation-linked bonds is the capital change from the rate of realized inflation. Simply if the headline rate is 5 per cent, then capital is indexed at 5 per cent.
In previous times, pre-QE to infinity days, inflation-linked strategies used a combination of inflation-linked bonds combined with a (short) nominal bond overlay. In this scenario the strategy pay-off is intended to reflect the degree to which inflation-linked bonds outperform the nominal bond. This difference is the breakeven inflation yield and the wider it gets a positive return is generated. Easy, but not so fast as how much of this inflation push is actually ‘inflated’ because of supply shortages. How long does Omnicom play havoc, and so forth?
What we do know is the US government has massive bond financing requirements. When, and if the Fed begins winding down its balance sheet after just two increases by September, the market is on course with having to absorb an additional $US150 billion of net Treasury issuance in the last quarter of 2022. Who know where that number will be with so many variables?
If Congress passes new spending in the Build Back Better Act or other renames spending bills net issuance would rise by more than $US210 billion this year. This realization as seen a flurry of corporate bond issuances to before the Fed raise rates is adding to Treasury weakness. The effects are many, and with many unknown bifurcations. When a small smooth change made to the parameter values of a system causes a sudden ‘qualitative’ or topological change in its behavior. Bifurcations occur in both continuous systems and discrete systems, which central banking is a glaring example. An important point to consider in the Mandelbrot set boundaries are the bifurcation locus of the quadratic family (not to overflow you with mathematics theory) that is, the set of parameters for which the dynamics changes abruptly under small changes of in the formula, if you think in Gann’s harmony of markets or the theory of reflexibility you can see where this can all end up potentially or just absorb it all with conflicting elements, stay tuned.
From The TradersCommunity Research Desk