For more: Quick Saxo Market Call podcast discussing this yield spike and implications.
Also: a chart deck to accompany that podcast and this article.
Our Q4 Quarterly Outlook is just out - you can find it here.
Everyone has a plan until they get punched in the mouth – Mike Tyson
Why are long rates rising so rapidly?
When FOMC & ECB decided to reinforce their higher for longer at their latest FOMC meeting they didn’t (as per usual) account for the cascading effect of Quantitative Tightening (reduction of their balance sheets) and fiscal dominance on yields.
From a 20.000 feet perspective we live in an economic and political world where Bidenomics or more precisely Modern-Monetary-Theory, MMT prevails. The premise of MMT here is that governments can issue infinite among of debt with no consequences for inflation or productivity and if inflation rises then you use the tax rate to reduce the excess demand. President Biden and the EU did the first part but could and will not be able to introduce tax rises.
This means we have a market where issuance of bonds (debt) exceeds available capital and hence forces the marginal cost-of-capital up. The market doesn’t believe any government will be willing to go back to a prudent fiscal policy and unfortunately they are right. Populism and delivering on green transformation and ESG is not only costly but in its present form it is a direct tax on consumers and business as it has negative productivity.
What does it mean for next policy action?
We have clearly reached a stage where something is breaking. The real rates are too high and the global economy is about to tilt down while central bankers are asleep at the wheel.
We expect FOMC members to start talking more about a cut in 2024 as “external factors” get worse. But more important is the spiking long end of the curve. There, the Fed will have to do some sort of indirect or implicit Yield-Curve-Control (YCC) first through flagging a needed policy shift that keeps the ten- to thirty year yields capped at perhaps 500-525 basis points (5.0%)
More practically, the FOMC can pause QT, or remove paying interest on excess reserves from the banking system. The latter has been a Fed subsidy to banks as it allows them to park money at the Fed at extremely attractive levels. Stopping interests payments on excess reserves will save the Fed $100-200 billion a year but will also force banks to buy short-term bonds for their regulatory capital.
The functioning of the short-term interest rates market and its velocity (speed of rises) is clearly indicating that if we stay in this environment for another week some kind of action is needed. We have reached something breaking and a “punch on the mouth” simultaneously. The central banks have again made a policy mistake and market is handicapping it even before the imminent slow-down in global growth. (We see two-thirds of global economies in recession, one-third in stabile/small acceleration).
Trading and investing stance in this environment?
One issue when volatility rises and risk contagion is on the loose is that assets all begin to line up along risk-on, risk-off fault lines, with a correlation approaching 1 or -1 depending on whether it is “risky” or “safe”. This makes hedging difficult, but the simplest thing to do is to reduce, reduce, reduce on the risk front.
With that said, some options for investors:
- Cash is King says the old motto. This is no risk, safe investment in times of ultimate uncertainty. Saxo offers very competitive cash rates depending on the account size.
- Hedge your portfolio of long individual stocks by shorting a single index-linked ETF or other instrument where appropriate. For US-equity exposed portfolios, for example, it might be appropriate to consider the SPY ETF (officially the SPDR S&P 500 ETF, which is the most traded ETF that tracks the overall S&P 500 index) or the QQQ ETF (the Invesco QQQ Trust Series 1), which tracks the Nasdaq 100 index.
- Rotate into short-term bonds. As per our Q4 Outlook: Bond(s) – Long Bonds out just yesterday, we favour short-term bonds. This is 2y government bonds which have very little sensitivity to changes in rates (expiry is less than 2 years out) while offering a solid yield. Saxo has great bond offering you can access directly in the platform. Levels present in yield: USD: 517 bps, GBP: 496 bps, Germany: 322 bps, Netherlands: 326 bps, AUD: 413 bps; Hong Kong: 418 bps; CHF: 118 bps. We like short-term bonds for two reasons: 1. Real Rates are too high for this party of the economic cycle. Expect them to fall (Either inflation lower or Yield Lower or both) while the carry (ie: the coupon paid) is fixed. The carry will substitute some or all of loss if rates are slightly higher or unchanged and of course benefit if yield comes off.
- Make sure leverage is taken down. One should minimise or eliminate gearing during times of turmoil.
Above all, though, don’t panic! This is about bracing your portfolio for volatile times ahead, and there are are ample ways to hedge risks for the short and medium term on the SaxoTrader – Our full Saxo team is available for consultation is needed and we will support through research and alerts over next few days as good as we can.