Last year Fed Chair Powell temporarily put inquiring minds to rest by telling reporters that the Fed was not even “thinking about thinking” about raising rates. Last week, in the aftermath of another pivot from easy policy to possibly tightening policy, he said that the most recent meeting was a meeting that could be called the “talking about talking” (of tighter policy) meeting. Powell is a lawyer, and one thing I know about lawyers is they always leave enough room to wiggle out by re-interpreting everything (in full disclosure I finished a year of law school in evening classes about two decades ago before having to put it on hold, and am happily married to a lawyer). This allows a Fed, led by him, to be uniquely qualified to change its mind when the facts seem to change. Powell himself has demonstrated the ability to make 180s when faced with new data, the most notable one being the pivot from a tightening bias in 2018 to an easy policy which might have a averted a market meltdown. Last week’s suddenly hawkish Fed and the stupendous (by bond traders’ measures) flattening of the yield curve shows another case of how learning to dance to the rapidly changing music of the Fed will become critically important.
Through an approach that statisticians and bond investors have learnt to use to simplify the gyrations of the bond market, the macro movements of the yield curve can be distilled into three major moves. These are called “parallel shifts”, “twists”, and “butterflies”. For bond dancers, “Shift-Twist-Butterfly” are three ways to dance. They are similar to combining notes to make chords, and chords to make progressions in music. As in music, these simple patterns repeat, and just as musicians can communicate moods with simple combinations of these fundamental musical phraseologies, the market distills the information from the Fed in terms of these three key movements of the yield curve. Typically about 80% of yield curve moves are shifts, about 15% are twists, and the rest are higher “harmonics” of the yield curve. Last week was mostly a twist, as levered carry trades that depend on the difference in yield between long and short duration bonds were rapidly unwound, as the first signs of short rates going up became evident. The yield curve slope between the two-year and thirty-year point flattened by almost 0.25% in a week which is notable because the yield of the two year is still around 0.25%, so all the action is in the long end of the yield curve.
The impact of this new tune will likely turn out to be most evident in the area of inflation protected bonds, and then show up in all other assets. Treasury Inflation Protected Securities, or TIPS as they are called, obtain their prices from “real”, as opposed to nominal yields. Today, even with the economy having rebounded vigorously, real yields in the US are in deeply negative territory. The five year TIPS yield rose by almost 15 basis points on the day of the new pivot, while still yielding minus 1.5%. In other words, for investors buying this bond, even if inflation were to turn out to be 2% over the next five years annually, the nominal return would only be 0.5%. More important, the five-year real yield sliced like a knife through butter through the broadly watched 200 day moving average, and if technical analysis is to be believed, is headed towards 0%, albeit this may take months to happen (Source for all data here is Bloomberg).
Most investors think that the real yield should track the real economy over the long run. The real economy should, in the long run, be a function of the real productive capacity of the workforce. So a negative real yield, if it were accurate, would reflect that the real productive capacity of the economy is going to be negative. With demand booming, prices rising, and the public beginning to splurge on travel, restaurants and theme parks, it is very hard for anyone to credibly argue that the real growth of the economy over the next five years is going to be that negative (negative 1.5% a year). So negative real yields, which is primarily the doing of the Fed (it purchased more than the amount of TIPS issued recently), has forced the Fed into a corner. And the only way out of this corner for the Fed is to dance to a brand new tune, and allow real yields to drift higher, maybe even into positive territory.
The TIPS yield curve twisted even more aggressively, as the rise in short term real yields was countered with a fall in long term real yields signaling possibly a cooling down of the economy to a sustainable place over the long run now that the Fed is paying attention to rising price pressures.
Another clue on why this might be part of the new song that the Fed will start to sing is that the five year forward five year breakeven inflation rate, widely followed as the expectations of forward inflation rate, has reached a comfortable value right above 2%. Since the Fed essentially controls this forward breakeven rate today by their marginal buying and selling of both nominal and real bonds, it makes sense that the Fed went from the tune of “substantial further progress” (i.e. easy policy to replace 8 million jobs missing) to pivoting, to possibly a taper and an earlier-than-expected tightening. They can now declare victory in getting the market inflation expectations (which they actually control) to their target.
The Fed’s brand new FAIT framework, which I have previously called “FAITH” (Flexible Average Inflation Targeting with Hope), basically allows for pivot(s) to become part of policy. We can maybe even call this new policy the PITS framework, i.e. Pivoting Inflation Targeting of Sorts, where the pivot itself depends on what the Fed thinks real-time inflation is. Bottom line, the hope turned to reality too quickly, and last week’s events should not be shocking to even those who expected Powell to pivot, because this is how a data dependent Fed will behave – they have already told us so.
The problem is that no one has any idea of whether the current inflation data is likely to persist. In other words, the Fed had the market convinced that it believed in the “transitory” nature of inflation, but now it is acting as if it is not that confident in that forecast because it has no idea either. Therein lies the conflict – while the Fed wants the market to believe that it will react to actual, not forecast data, it is implicitly making the forecast that inflation is going to be transitory, maybe. So, the Fed wants to be flexible, but also wants to change its mind about its flexibility if the data starts to disagree with its forecasts!
For investors, the message is clear – first, real yields are likely to rise to allow the cognitive dissonance of negative TIPS yields to resolve with evidence of a booming economy. Passive investors in bond markets, especially those who have bought TIPS on the back of the Fed’s purchases are likely to find out how painful even bonds can be, because rising real yields can drive the returns of all bonds negative, unless inflation nosedives, which is looking more and more unlikely. This includes many passive funds that not only own negatively yielding real bonds, but also negatively yielding nominal bonds from Europe and Japan.
In a world where the Fed is likely to change its mind not only about the best policy posture but also between flexibility and some sort of rules, interest rate volatility is likely to rise sharply. Since interest rates are so low, rising interest rate volatility means that volatility across all assets can rise sharply and suddenly because of the fundamental nature of interest rates in pricing all assets.
Markets today are conditioned to the Fed being able to squash volatility by buying all types of assets. This may not be the best bet to make if the Fed itself is increasingly uncertain about its own path and response function, and the only way for it to exit out of that corner is by aggressively pivoting, yet again. And by the way, for those who are curious, that “butterfly” dance of the bond yield curve is deeply related to the volatility in the yield curve. The sooner investors learn to change their own dance before the music switches, the more likely that they will survive on the new dance floor.