Treasuries: shallow pond, bigger waves
It is something of a joke among financial journalists that market moves on the afternoon of Fed meeting have no relation whatever to what the market will do the next day, after it has had a few drinks and some sleep.
So it played out this time around. Immediately after the Federal Reserve news dropped on Wednesday, 2-year bond yields leapt, fell, then rose again. The Nasdaq stock index fell, rose, then fell hard. But by yesterday the market had its mind made up.
Two-year yields popped back above four, and the Nasdaq fell, but that was not the interesting bit. The real action was in longer-duration Treasuries. Five- and 10-year yields both rose 20 basis points, very chunky moves. For Unhedged, they were painful moves, too, given that I had recently written approvingly of owning longer-duration bonds (yields up, prices down, remember). Either better inflation data or a Fed-driven recession would help long Treasuries, I had pointed out. For now, though, we have neither of those.
The whole move up in long bond yields this year is explained by real yields (that is, higher yields on inflation-protected Treasuries), not by higher inflation expectations, which are down. So the simplest interpretation of what has been going on is that faith in the Fed is deepening. People increasingly believe the central bank is going to be tough, and the toughness is going to work. What we’ve gotten in the last few days is another dose of that.
(This has been, incidentally, hideous news for believers in gold, which is billed as a hedge against inflation but is really a hedge against falling real rates. We’re in the most miserable inflationary incident in 40 years, and gold is off 15 per cent since April. Oof.)
A word of caution on reading too much into intraday moves in bond yields, though. As we have noted, Treasury market liquidity has been terrible. Below is one measure of it, Bloomberg’s US Government Securities Index. which measures how much realised Treasury prices are distorted by wide bid-ask spreads, compared to a fair value model. The index is showing stress levels comparable to the early days of the pandemic:
Given this, there may be less information in yield moves than there appears to be. Little eddies in other markets — the Japanese central bank selling dollars, say, or an unsteady market for UK gilts — might cause waves in the increasingly shallow Treasury market.
Sometimes there is a complicated story about what is moving an asset. Not so the yen. The currency is facing multi-decade lows because of rate differentials. That’s really it. The Bank of Japan thinks it has a chance to kill deflation for good, and so has chosen to cap Japanese 10-year yields at 25 basis points. Virtually every other global interest rate is rising. Capital flows to where rates are highest. Right now that means capital flowing away from the yen.
Whether a weak yen is good or bad for Japan is open to debate, but either way, Japanese officials are concerned the yen is depreciating too quickly. But raising rates appears to be out of the question. So the government is fiddling around the edges, instead. From the FT:
Japan intervened to strengthen the yen for the first time since the late 1990s on Thursday, after the currency tumbled to a 24-year low on pledges by the central bank to stick with its ultra-loose policy.
Masato Kanda, the country’s top currency official, said the government had “taken decisive action” to address what it warned was a “rapid and one-sided” move in the foreign exchange market. It was the first time Japan had sold dollars since 1998, according to government data . ..
The move, which traders said was conducted shortly after 5pm local time in Tokyo, caused the yen to surge to ¥140.34 to the dollar in the space of a few minutes.
It looks a bit futile. Japan has more than $1tn in foreign-exchange reserves, but that is against the $1.1tn changing hands every day in the yen spot market. FX interventions in a market that large can only be sustained for so long.
At the same time, though, volatility from intervention, or the threat of it, could shake out leveraged yen shorts, slowing the pace of depreciation. That appears to be what Kanda is getting at in comments saying the government took “decisive action” in the face of “speculative moves.”
The Bank of Japan may not need to stall much longer. No one knows when the Fed will stop raising rates but the central bank’s projections put us at 4.4 per cent by year-end. The market anticipates that the peak rate is only a bit higher than that. Craig Botham of Pantheon Macro calculates, based on IMF research, that if Japan spent all its currency reserves, it could boost the yen 48 per cent against the dollar. Achieving a less ambitious target — such as stabilising the yen for a few months — could probably be done without exhausting the country’s FX resources.
Even if the Fed keeps marching rates up indefinitely, the yen might not be condemned to weakness. As Corpay’s Karthik Sankaran pointed out to me, at some point high rates will cause a recession and crush US assets, possibly giving Japanese investors abroad (Japanese pensioners who own US assets) a strong incentive to move back to the yen:
Obviously they’ve done really well since 2012, because US stocks have had a great run and dollar-yen has had a great run, especially over the past nine months. So the question is: do they think that keeps going? Or do they take profit? Do they hedge? Do they say, OK, let’s take something off the table. Let’s at least convert the interest payments on our dividends back to yen.
We suspect yen weakness is near its peak. Email us if you think otherwise. We’ll be writing more about Japan next week. (Ethan Wu)
One good read
“So what if we had 3 per cent inflation for a while?”
Read the full article here