Yields & Rates roundup

This last week of February was probably the most eventful week in the Fixed-income space after March 2020. On the 25th, both stocks and bond prices seemed to be falling into a downward spiral after a disastrous 7yr auction which ended with a ~4.4bps tail. Although the move in equities was just ~3%, the implications were probably much greater.

Treasury prices saw a big fall across the curve but the major dislocation was in the belly of the curve with the 2s5s30s having an off-the-chart day with a move of >20bps. The 5yr was down a complete handle on the day with yields closing 16bps up this week to 0.73%.

The real problem this time wasn't probably the change in yields but the rate-of-change in yields. Although the FED indeed may want the market to price in a good future economy, such a quick change may have the opposite effect as it may serve as a trigger for interventions.

The inflation question is also looming right now, which makes the possible reasons for this sudden market move especially important. This is a key issue as the result of an eventual FED intervention might also have very different effects depending on whether we are pricing reflation or inflation - even as both have similar signs in the initial stages (wider TIPS breakevens, booming commodity prices etc etc..)

Thursday was also a big day in STIRs market with Eurodollar volumes spiking massively and futures pricing in a first full rate-hike in Q1 2023. The market seemed to be pulling rate-hike expectations forward - earlier than what the FED seems to be signaling for. Although such discussions may be highly pre-mature, there has been some chatter about whether this is a policy error pricing. (Links to that discussion below)

In recent history, the rates markets have lead the way on the downside, almost dictating to the FED what was ought to be done (both in 2018 and 2020). Will the same happen on the upside as well? Probably.

Intervention?

Some analysts from Citi have been quoted as speculating that the FED may not react just yet and may not intervene till we see ~2% levels in TY yields and/or a substantial fall in equities.

“It is unlikely that the Fed will let US real yields rise much above 0%, given high levels of public and private sector leverage,” analysts on Citi’s global strategy team wrote in a note dated Friday titled “Rising Real Yields: What to do.”

Most businesses, however, do fund themselves at the short end of the curve and a steepening yield curve is better for banks as well - in this scenario, the big question right now is whether the FED can allow the long end to run amok while retaining its focus on the short end of the treasury curve. This question is a can question and not a will question. The FED has discussed yield-curve control earlier in its June 2020 meeting and its views on the same can be understood from these FOMC minutes.

The Reserve Bank of Australia recently bought $4B worth of bonds (more than it did in March 2020).

While it may be a possibility that the FED does nothing even if the markets remain unruly (although there has to be a tipping point), it must be understood that there are real-world complications of higher long-end rates which the FED will clearly want to avoid. For example, ripple effects might show themselves up in the real estate market where something like a 30yr fixed mortgage prices itself off the 30yr Treasury.

It will be important to track what the long list of FED speakers have to say this week as we try and understand how the FED is going to approach this scenario. There are clearly milder ways of influencing the yield curve as well without going all YCC on the market. As suggested by BoFA, the FED will likely use 'qualitative guidance' and determine a long window to set expectations of any upcoming policy changes.

Impact on Equities | Source: Goldman Sachs Invesment Research

It must be remembered that this move in yields/rates was happening in the backdrop of vocal lobbying for a SLR exemption for Treasuries. (see Pozsar on Feb25 and Feb16 for context). This situation is another challenge before the FED which it will have to maneuver through carefully in March.

Finally, it does seem like the STIRs market will not be as boring/subdued as what was initially thought. While a lot of the focus right now will shift to fiscal policy (stimulus..), the fixed-income markets will probably continue to keep the FED in check - after all someone has to.

Update: As of 1st March, 2021, there has been some pullback in yields and the 2s7s30s flies (and others).

Below are some links to follow what actually happened on the 25th and the various views/opinions on what it means for the markets.

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raghav duseja

Yields & Rates roundup - Feb 2021

Intervention?

Articles

Belly of the Treasury curve

Liquidity situation

STIRs

Discussions: understanding the context

1st, March, 2021

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