Get free daily updates on the markets! Subscribe to our myFT Daily Digest email to stay informed about the latest news in the markets. Welcome back, Unhedged readers! In yesterday’s newsletter, Ethan discussed the recent Fed meeting, highlighting Chair Jay Powell’s decision not to celebrate the recent improvements in inflation. I believe this cautious approach was strategic. Despite having the highest interest rates in 22 years, stock prices are rising, and credit spreads are narrowing. Any indication from Powell that the Fed is done raising rates would have sent riskier assets soaring, further loosening financial conditions and making the Fed’s job more challenging.
Today, I want to delve into how the Fed’s decision aligns with the strong US GDP data released yesterday, and whether a soft landing could be on the horizon for those of us on this side of the Atlantic. Additionally, I’ll share my concerns about the significant surge in Treasury bond issuance expected later this year. Let me assure you that I’m not a budget hawk; I’ve been writing about the Treasury market for years, and its expansion since 2008 has created potential risks to financial stability. Feel free to direct your complaints to [email protected].
GDP:
According to the Department of Commerce, the US economy grew at an annualized rate of 2.4% in the second quarter, surpassing the 1.8% forecasted by economists surveyed by Bloomberg. This growth rate is also higher than the 2% recorded in the first quarter. Although consumer spending slowed after a strong start to the year, this dip was offset by increased business investment.
With solid economic growth, a strong labor market, and a deceleration in inflation, the conditions seem ripe for the Fed to achieve a soft landing – a controlled slowdown in inflation without a significant economic downturn. This outcome becomes even more plausible if the Fed chooses to halt its rate hikes, as indicated by Powell this week. James Knightley, chief international economist at ING, believes that robust growth, decelerating inflation, and declining weekly jobless claims contribute to the narrative of a soft landing.
Market reactions to the GDP data were mixed, with stocks slightly down and the 10-year Treasury yield, which moves in response to growth expectations, experiencing a significant increase. However, many are finding it difficult to fully embrace the positive news. Eric Hickman at Lantern Capital pointed out that strong GDP figures preceding recessions are not uncommon. For instance, in July 2000, second-quarter GDP was 5.2% (exceeding the consensus forecast of 3.8%), and a recession began eight months later in March 2001. Similarly, in October 2007, third-quarter GDP was 3.9% (above the forecast of 3.1%), and a recession followed two months later.
The market is still grappling with the unpredictable time lags associated with monetary policy. Kristina Hooper, chief global market strategist at Invesco US, suggests that we may be headed towards a bumpy landing. While she does not foresee a severe downturn that destroys jobs due to the strength of the labor market, Hooper remains cautious about the sustainability of current growth and credit conditions.
Treasury Issuance, once again:
If the Fed is indeed done raising rates and inflation continues to slow down, a logical trade would be to add longer-maturity bonds to your investment portfolio. Investors had been avoiding duration, given concerns about high inflation and rapid rate hikes. However, as Rob highlighted in a recent article about the 10-year Treasury, locking in a 3.8% yield for 10 years seems attractive when compared to pre-pandemic yields consistently below 3%.
There is evidence indicating that investors are starting to pursue this strategy. According to the Commodity Futures Trading Commission data, asset managers currently hold their longest net position in 10-year Treasury futures. Additionally, the Bank of America rates and FX sentiment survey suggests that US investors have an almost 20-year record exposure to duration.
Nevertheless, there is a looming risk associated with this increase in duration. In my previous Unhedged article, I discussed the potential market impact of a flood of new Treasury bills. Fortunately, this concern has not materialized, as the Treasury bills issued so far have been absorbed by money market funds, neutralizing their impact on the financial system. Cash used to purchase the new Treasuries originated outside the financial system and remains outside in the Treasury general account.
However, there is another wave of Treasury issuance that could pose challenges for the market, particularly for those investors accumulating longer-maturity bonds. While the Treasury has primarily relied on short-dated bill issuance to raise funds, it is anticipated to announce an increase in the sale of longer-dated bonds next week for the first time since 2020. Mark Cabana, head of interest rate strategy at Bank of America, warns that the US will need to borrow more money later this year to support fiscal programs, resulting in a net sale of $535 billion in two- to 30-year bonds between July and December. Cabana recognizes that the market currently favors longer duration but reminds us that the consensus view often meets surprising results.
A surge of long-dated bond supply flooding the market could push yields higher, disrupting the long-duration trade and increasing borrowing costs for US companies. In the best-case scenario, the market easily absorbs this increase in supply, resulting in minimal fluctuations in yields. However, that may not be the case this time as many natural buyers of long-dated Treasuries have left the market. The Fed is shrinking its balance sheet, commercial banks’ demand for Treasuries has decreased due to deposit shrinkage, and foreign buyers are discouraged by high currency hedging costs. With diminished demand, Treasury prices may need to adjust downward.
One might wonder why investors eager to bet on long duration wouldn’t simply purchase all the new long-dated debt. Firstly, the depth of demand for long duration remains uncertain and may not be sufficient to absorb the surge in supply. Secondly, the market will continue to experience increased supply in the coming months, gradually diminishing the appeal of the long duration trade.
Recommended Reading:
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