The Sound of the Fed’s Silence
There are ways of overcoming modesty. Central banks customarily go into self-imposed silence ahead of important monetary policy meetings. In Britain this is nicknamed “purdah,” after the religious practice of separating women from men with a curtain. With the Federal Open Markets Committee due to meet Wednesday, there was no way policy makers could guide the market on how last week’s awful inflation data for May had changed their plans. But somehow people got the gist.
This is how the fed funds futures market’s projection for Wednesday’s FOMC has moved over the last four weeks. Suddenly late Monday, it moved to virtual certainty that the Fed will raise by 75 basis points, and not the previously projected 50 basis points:
What happened? It’s probably best to try reading the New York Times, Bloomberg News, Axios or the Wall Street Journal, all of which published stories about the likelihood of a 75-basis-point hike as the afternoon progressed. None of these stories feature any on-the-record comments from Fed officials since the inflation data came out in Friday. However, they are all framed the same way, and lead the reader through the same comments made before the quiet period that had given the Fed some wiggle room to raise by more than 50 basis points. We can assume that this was a coordinated attempt to guide the market through trusted journalists, while just about staying in purdah. This is one of those times when you believe what you read in the papers — the Fed has now set everyone up for a 75-basis-point hike on Wednesday. Anything else would be a huge surprise. The story, breaking first in the Wall Street Journal, arrived in time to accelerate what were already dramatic market moves.
This is how expectations for the fed funds rate as of the February FOMC meeting have moved, using the two methods for calculation in the Bloomberg World Interest Rate Probabilities function. A week ago that rate was less than 3%. Now it’s nearly 4%:
All of this has had ramifications. The 10-year Treasury yield, in a persistent downward trend for more than three decades, is now almost certain to rise for two quarters in succession. The vaunted trend line on which many had come to rely, consciously or otherwise, has now — it appears — been definitively broken:
The speed of the turnaround is breathtaking. Looking at real yields, as offered on Treasury inflation-protected securities, or TIPS, they dropped below -1% in early March as the world reacted to the shock of Russia’s invasion of Ukraine. After a steady ascent for three months, and a vertical gain in the last couple of days, they are now positive by 0.7%:
Tale of a Tantrum Foretold
There’s a name for this, and a fixed template: the “taper tantrum.” This is how history has dubbed the 2013 incident when real yields were also negative, and then-Fed Chairman Ben Bernanke started to talk about tapering the central bank’s asset purchases. The response was a sharp rise in real yields which sparked volatility throughout emerging markets.
If we compare real yields since August last year with 2012-13, the similarity is obvious:
This might imply some ground for comfort, as we are now approaching the equivalent of the point at which the 2013 tantrum peaked and burned out. It also suggests that a certain amount of turbulence might have been unavoidable, and that the Fed is playing the situation well. Sadly, however, that would not be accurate.
This is a tantrum chart very similar to the one above that we published in Points of Return on Feb. 26, 2021:
Note the year. In early 2021, the global economy was looking resurgent amid the vaccine rollout and extra stimulus payments in the US. Then, as in 2013, real yields started to rise from startlingly low levels. This was a challenge to central banks. Were they happy to let rates rises and capitalism take its course, or did they need to intervene? This is what I said at the time:
And so it came to pass. This was the era when the Fed was “not even talking about talking about” tapering asset purchases. Intervention to keep yields low continued with full force. The incipient tantrum of early 2021 was delayed by a full year.
It’s also important to ask what ended the tantrum of 2013. Again, it was intervention by the Fed, albeit of a very passive kind. Heading into the September 2013 FOMC meetings, sentiment had been close to universal that the first tapering of asset purchases would be announced. It wasn’t. Bernanke gave the market another three months to calm down, before eventually paring as gently as possible. Real yields peaked just before the “no-taper” FOMC, and then went sideways for more than a year afterwards.
What are the chances that the Fed surprises by being lenient on Wednesday, as Bernanke was in September 2013? Judging by the guidance given to my colleagues in the financial press, I would say roughly zero. Now real yields have reached September 2013, in possibly even more disorderly fashion, but the reality of inflation makes it impossible for the Fed to calm everyone this time.
This following chart updates my chart from February last year. In 2013, the Fed let the tantrum rip for while, and then calmed things down which it still had the ability to do so. In 2021, the Fed suffocated the tantrum with more easy money, which allowed inflation to intensify. Now, with inflation having gained momentum, it is no longer able to calm things down:
The relationship between central banks and bond markets is, as I’ve said before, a lot like that between a parent and an angry toddler. Indulging the bond market early last year might prove a critical mistake in losing parental authority for the Fed.
Meanwhile, other central banks are under pressure of their own. In Europe, the yield on 10-year Italian BTP bonds topped 4%, for the first time since the first week of 2014, after a frighteningly vertiginous ascent. This has nothing to do with any specific news out of Italy, and everything do with signs that rates in the euro zone and the US are going to be rising a lot. It’s almost a decade since the European Central Bank promised to do “whatever it takes” to save the euro, and surprisingly the market never forced the ECB to prove this. Now, the issue of how to prevent euro fragmentation, with all the thicket of legal and political issues it raises, is unavoidably back. With the ECB under new management, it may at last be called upon to fulfill its promise. As with the Fed, that’s much harder to do when inflation is running far ahead of target:
But the real problem could be for the Bank of Japan, the exception to all global monetary rules. It instituted a revolutionary policy of “yield curve control” way back in early 2016, as the country’s stocks went into a bear market and Asia battled to deal with the impact of a sudden Chinese devaluation. Effectively, the BOJ promised not to let the 10-year yield rise above 0.25%. Merely saying this was enough to send the JGB yield steeply negative. Like the ECB’s “whatever it takes” promise, it was a signal that had its own effect.
Now, just like the ECB’s promise, the BOJ’s yield curve control is being put to the test. As of now, the 10-year JGB yields a fraction above 0.25%:
Keeping it as low as this has involved a massive deployment of resources. This remarkable chart from George Saravelos, foreign exchange strategist at Deutsche Bank AG, shows that the BOJ had actually been able to reduce its level of intervention during the pandemic. Now, it is shooting upward even as the Fed has abandoned asset purchases altogether:
This intervention is purely about domestic monetary policy, but it also has the effect of weakening the yen. Both the BOJ and the Ministry of Finance, in a rare display of unity, made clear last week that they were uncomfortable with the yen’s low level. That didn’t stop the currency from dropping below 135 per dollar for the first time since the Asian financial crisis in 1998.
Can the BOJ possibly keep this up? We’ll know Friday, but the market sentiment is that something will have to give soon. Direct intervention to strengthen the yen is hard to justify as it is currently being driven by orthodox domestic economic factors. So does the BOJ abandon yield curve control, or at least permit yields to rise to 0.5%? Probably.
That will have ramifications. Germany and Japan have come to be regarded as reliable suppliers of very cheap money. The ructions of the last few days are driven in large part by the realization that German rates can no longer be relied on. The BOJ’s meeting could yet prove even more consequential for the world than the FOMC’s two days earlier.
Yes, there is also now an “official” bear market in the US for those who hold that an index needs to drop 20% before such an event can be declared. This was a top-down selloff if ever there was one, and nothing matters more to the stock market in the near term than the decisions of a few central bankers. But to give a little anatomy to this bear, it’s interesting to see where the pain has been felt most. Seven large companies jointly account for 42.5% of the index points the S&P 500 has lost since its peak in January:
The big FAANG stocks have begun to take on at least some of the trappings of Treasury bonds in the last few years. Big and reliably liquid pools, they were a safe place to put money. Portfolio managers could also take profits in a hurry. If you need cash, it’s never difficult to sell a FAANG.
The scale of the money lost in these companies is now mind-blowing. Six companies — the ones in the chart minus Nvidia Corp. — have at one point had market valuations above $1 trillion. That epic wealth creation has unfortunately turned to destruction. This is the market cap of the six trillionaires at peak, compared to now. Warren Buffett’s Berkshire Hathaway Inc., the largest non-FAANG stock in recent years, is included for comparison:
Apple Inc. is the only company still worth more than $2 trillion, but its total reduction in value since January is equivalent to more than one whole Berkshire Hathaway at its peak.
None of these companies is endangered by the fall in its share price. But the same may not be true of their investors. The losses that really cause systemic problems are those that investors assumed they wouldn’t face. Crypto asset prices are tumbling, but it’s unlikely many people truly regarded them as stores of value. What is most concerning about the bear market so far is the fall for apparently low-risk or even risk-free investments. Since the S&P 500 peaked Jan. 3, both long bonds and FANG stocks have dropped more. Those bear markets may be more deadly:
How could you have protected yourself these last few months? In energy stocks, of course. Massive rises in the price of oil will have that effect. But what’s fascinating, as I begin to work out what trades Hindsight Capital LLC should have put on this year, is that a trade of buying the S&P 500 Energy sector and shorting the NYSE Fang+ index started to work long before the turn of the year. Energy stocks bottomed relative to mega-cap tech stocks at the end of the week of the presidential election in November 2020. That was followed by “Vaccine Monday,” when positive test results for Covid inoculations brought animal spirits back with a roar. I’ve circled it in this chart:
Markets always look simple with hindsight. But with Biden in the presidency and pumping up fiscal support, and with the vaccines in circulation, might the Fed not have decided to let the bond market have its hissy fit a year earlier than it did?
One final thought. This is a terrible time for duration — those securities most sensitive to changes in interest rates. And there’s nothing more sensitive to rates than a really long-term bond. It’s now almost five years since Austria launched its “century bond,” which won’t repay principal until 2117. By the end of 2020, its price had more than doubled. Now it’s 20% below its initial price. Anyone who bought at the top has lost two-thirds of their money. Look on its works and despair!
OK, bears aren’t all bad. Some of my favorites include: Paddington (who gets his name from a railway station); Rupert; the Berenstain Bears; the Hair Bear Bunch; Yogi Bear; and of course Winnie the Pooh, although what Disney did to him does give me a toothache. To survive this bear market, the Tao of Pooh may be more helpful.
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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
John Authers is a senior editor for markets and Bloomberg Opinion columnist. A former chief markets commentator and editor of the Lex column at the Financial Times, he is author of “The Fearful Rise of Markets.”