Equities: New extremes and a challenging opportunity set
Discover insights on the future of equity markets in Q1 2024 and navigate the potential recession with strategic investment choices.
Chief China Strategist
Summary: The Fed is moderating the pace of rate hikes into 2023 but inflation is likely to be stubbornly elevated. The combination of these creates an environment in which Treasury Inflation-protected securities (TIPS) could potentially be an attractive investment option. Declines in real interest rates will see TIPS prices higher and their principal value and coupon amounts (while the coupon rates are constant) will rise together with the consumer price index.
As our previous Fixed Income Update suggests, the modus operandi of the Fed has arguably shifted to risk management which aims at balancing the risks of inflation and the yet-to-be-fully-felt impact of monetary tightening on the real economy. Fed Chair Powell signals in his speech at the Brookings Institution on November 30. 2022 that being sufficiently restrictive, in his mind, is likely just “somewhat higher” than the 4.50%-4.75% (mid-point 4.625%) terminal rate in the FOMC’s September projections and he argues for “moderating the pace” of rate increases and “holding policy at a restrictive level”, not keep hiking, “for some time”. Powell acknowledges the fact that the employment, wage growth, and core services ex-housing inflation are all too strong to confidently foretell a victory in fighting inflation anytime soon and admits that the Fed has “a long way to go in restoring price stability”. Nonetheless, resorting to the notion of impact lags of monetary policy, Powell argues that it “makes sense” to downshift rate increases.
This may mean that after a 50bp increase this Wednesday, as being well telegraphed and fully priced in, and probably another 50bps to 75bps in total in the February and March 2023 meetings. Powell has apparently on purpose been preparing the market that the Fed may pause even without seeing inflation falling significantly towards the 2% target as he and the November FOMC minutes emphasized the time lags of monetary policies and the importance of financial stability. Since August 2020, the Fed has adopted a new set of a new monetary policy framework that redefines its 2 percent inflation goal not as a ceiling but as inflation averaging 2 percent over time, and the unspecific “average over time” gives the Fed room to maneuver.
Alice looked round her in great surprise. “Why, I do believe we’ve been under this tree the whole time! Everything’s just as it was!” “Of course it is,” said the Queen, “what would you have it?” “Well, in our country,” said Alice, still panting a little, “you’d generally get to somewhere else—if you ran very fast for a long time, as we’ve been doing.” “A slow sort of country!” said the Queen. “Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!” “I’d rather not try, please!” said Alice."
Lewis Carroll, Through the Looking-Glass.
After running as fast as it can with 375bp hikes including four 75bp hikes, since March 2022, the Fed ends up in a situation where inflation rates are not accelerating further but stay at elevated levels and are not coming down. Inflation rates as represented by the key measures on which the Fed is focusing are more or less at the same place as when the Fed started raising rates nine months ago (Figure 1). In his Brookings Institution speech, Powell highlighted the personal consumption expenditure core services ex-housing index being a key indicator for the future path of inflation because he is least confident for this component to fall, as opposed to prices of core goods and costs of housing services.
Likewise, the three measures of wage growth to which the Fed refers are at basically the same place as the Fed start raising the Fed Fund target rate in March 2022 (Figure 2). Elevated wage growth rates tend to fuel inflation, and high inflation raises demand for higher wages.
While the Fed may not have yet caught up with the runaway inflation train even after running very fast since March this year, it is signaling that it wants to switch to a low gear and hope that the cumulative rate hikes working through the proverbial impact lags, plus the ongoing quantitative tightening will work their wonder in bringing down inflation.
As inflation remain elevated, the Fed can downshift the pace of rate hikes but does not have room to pause or cut rates in the next few meetings. Therefore, three-month T-bill rates (currently at 4.23%) will become a floor to the 2-year yield. Unless the Fed’s next move is a rate cut, which will not be the case, 2-year yields will unlikely fall below the yield of 3-month Treasury bills. As illustrated in Figure 3, during the five times over the past 30 years when 2-year yields fell below 3-month yields, the next move by the Fed was cutting rates. When the Fed was not about to cut rates, yields on the 2-year notes did not fall below those of the 3-month bills. When 2-year notes are yielding only 4.33%, they offer little investing value. While we are expecting bonds to be a valuable asset class to have in a portfolio in 2023, we caution investors to be patient and look for a better entry level.
At Saxo, it is our view that the U.S. is not entering into a recession. Without a recession that drags down inflation and pushes up unemployment rates substantially and therefore brings about a series of rate cuts, the term premium is unlikely to stay so negative. In other words, investors will demand higher yields to compensate for the risks of owning long-term bonds. This is particularly true when the interest rate volatility is high. Higher implied volatility of treasury yields demands higher term premiums, i.e. higher long-term yields relative to short-term yields. Figure 4 plots the 3-month Treasury yield versus the 10-year Treasury yield spread against the ICE BofA Merrill Lynch Option Volatility Estimate (MOVE) Index. The divergence between the inversion of the yield curve and the elevated level of the MOVE index is unusual and may point to pressure for yields on 10-year notes to go up.
The Fed does not fear a recession or prolonged bear market in equities. It may welcome both as they help the Fed strive to dampen the development of a wage-price spiral and tighten financial conditions. It is the functioning of the Treasury market that is the elephant in the room and keeps Powell up at night.
In the Fed’s own words in its November FOMC minutes, the U.S. Treasury market is important “for the transmission of monetary policy, for meeting the financing needs of the federal government, and for the operation of the global financial system. The FOMC participants noted that “the value of resilience of the market for Treasury securities was underlined by recent gilt market disruption.” In its Global Financial Stability Report Oct 2022, the IMF warns about poor market liquidity in government bond markets as quantitative tightening “leaving more of these bonds in private hands, which could translate into a shallower pocket to absorb shocks and therefore higher liquidity premiums and lower market liquidity.”
As the total amount of outstanding Treasury securities has surged by seven times from USD3.2 trillion in 2002 to USD23.7 trillion in November 2022, the average daily turnover of the Treasury market has less than doubled during the same period. As a result, the average daily turnover as a percentage of the amount of outstanding Treasury securities has declined from 11.6% to 2.6% over the past 20 years (Figure 5).
Using the deviation of the quoted prices of individual securities from the fair-value curve as a proxy for market liquidity (Figure 6), the liquidity of the Treasury market has drastically deteriorated and stays currently at an elevated level similar to those in March 2020 when the Fed decided to come to the rescue and start a new round of open-ended buying of Treasury securities, i.e. quantitative easing.
What if inflation does not come down and raising interest rates not “somewhat higher” but much higher, together with quantitative tightening, risk draining market liquidity and breaking the Treasury securities market? Not speculating on the political dynamic between the Fed, the White House, and Congress, the Federal Reserve Act of 1913, under which the Fed operates, provides that:
The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates. Section 2A. of the Federal Reserve Act
The notion of moderate long-term interest rates is a goal imposed on the Fed by law, though the Fed has certain leeway to decide on what “moderate” is. The Fed usually talks about a “dual mandate” of monetary policy without mentioning the third one because the Fed considers that “an economy in which people who want to work either have a job or are likely to find one fairly quickly and in which the price level (meaning a broad measure of the price of goods and services purchased by consumers) is stable creates the conditions needed for interest rates to settle at moderate levels”, without the need to define what “moderate levels” are.
It may not be the case when bond investors become fed up with the elevated inflation rates and a Fed not willing to run any faster than what it has done to keep up with inflation in a liquidity-strained Treasury market. It was alarming when Treasury Secretary Janet Yellen warned publicly about “a loss of adequate liquidity in the [U.S. Treasury securities] market” in October. As the Fed is busy trimming its holdings of Treasury securities at a pace of USD95 billion a month as qualitative tightening, Secretary Yellen is worried enough to prepare to open her wallet and buy back Treasury securities. In October, the Treasury Borrowing Advisory Committee asked around primary dealers about their responses if the Treasury Department putting in place a debt management program to buy back long-term treasuries and said in its report in November 2022 that the Treasury Department “should continue to gather information as to the benefits and risks” of bond buybacks.
The move highlights the Treasury Department’s concern about its costs and even abilities to fund the U.S. Federal Government’s budget deficits through issuing Treasury securities and the amount of federal debt held by the public as a percentage of U.S. GDP has ballooned to nearly 100% this year and is heading towards 110% by 2032 (Figure 7), surpassing the peak at the end of the Second World War. It was noteworthy to remind our readers that from 1942 to 1951, the Fed implemented yield curve control and capped the Treasury long-term bond yield at 2.5% to help the Treasury Department finance the federal government at low interest rates and bring debt down.
The total return on Treasury inflation-protected securities (TIPS) tends to outperform that of nominal bonds when real yields are falling and the Consumer Price Index for All Urban Consumers (CPI-U) is rising or simply stays at elevated levels higher and more persistently than previously expected.
TIPS are quoted and traded in real yields that can be positive or negative. When the real yield rises, the price of TIPS falls; when the real yield falls, the price of TIPS rises. The most unique feature of TIPS is the principal value varies and is indexed to the CPI-U. The index ratio is calculated by the CPI-U index value published three months before the settlement date divided by the CPI-U index value as of the issuance date of the TIPS. For days during the month, linear interpolation of the monthly CPI-U indices is used. The Treasury Department publishes the updated index ratios for all TIPS issues on its website.
When the CPI-U index value rises, i.e. inflation is positive, the principal value of TIPS will rise by the same percentage. When the CPI-U index value falls, i.e. inflation is negative, the principal value of TIPS will fall. The coupon rate of a TIPS is constant and does not change over the life of the bond. However, the coupon payment will change over time proportional to the change in the principal value. Therefore, the principal and coupon cash flows, that the investor receives, are protected from inflation.
What is not protected is a rise in the real yield of TIPS that reduce the quoted price of the bond. When inflation is positive and even increasingly positive but the real yield is rising fast, the increase in the inflation-indexed principal may not be sufficiently large to offset a decline in bond price and the investor ends up with a loss in total return. From March, the month the Fed started raising rates, to October 2022, the TIPS yield swung dramatically from negative to positive as the Fed raised interest rates aggressively. The 10-year TIPS yield soared from minus-1.0% on March 1, 2022, to positive 1.6% on October 31, 2022, a 2.6% or 260bp movement which caused the 10-year TIPS to fall 21.4% in price. The rise in principal value contributed 5%. The net loss over that eight months was 16.5%. Rising inflation is not enough to generate a positive return for TIPS investors if the Fed aggressively pushes up real interest rates like it did this year. Many investors asked why TIPS lost money in most of 2022 through October and the 260bps rise in the real yield is the answer.
The investment environment has become more favorable for TIPS since November 2022 when the Fed signaled to the market that it will downshift the tightening pace even before inflation falls substantially.
In Figure 8, the green, light blue, and dark blue lines are breakeven inflation rates implied by the difference between yields on nominal Treasury note yields and the yields on TIPS, which are real yields. The bond market is pricing in future inflation at very near to the Fed’s 2% target as investors believe that the Fed will be able to bring down inflation towards 2%. In a combination of stubbornly high inflation and the Fed’s downshift in the pace of tightening, the line of least resistance for breakeven inflation is going upward, approaching the elevated actual inflation and away from 2% rather than falling below 2%.
The breakeven inflation is the difference between nominal Treasury yields and TIPS yields. As inflation turns out to be more persistent into 2023, nominal bond yields are likely to bounce from this current trough level and rise to test the October 4.34% high in yield. However, given the Fed is mindful of the liquidity in the Treasury securities market and not to disrupt its smooth function, the rise in yields will be measured and much behind the rate of inflation. The aggressive pace of raising interest rates was something for 2022 and will unlikely be repeated in 2023. In this environment, for the breakeven inflation to rise, TIPS yields will probably need to fall. That will give TIPS a sweet spot of elevated inflation and at the same time declining real yield. Currently, 5-year TIPS are at 1.44% and 10-year TIPS are at 1.31% (Figure 9) and have room to fall in yield and rise in price. On top of that, the principal of TIPS is rising at the same rate as inflation as it is indexed to the CPI-U. Current inflation assumptions used for index factor calculation are around 8% p.a.
In Figure 10 below, a list of TIPS is shown for illustration purposes.
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