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'Taper' Tantrum 2.0

Feb 22, 2021

Executive Summary

  • Interest rates are rising with a speed that is being referred to as the "taper tantrum 2.0"
  • Are yields really rising due to an expectation of the Fed reducing the size of its balance sheet? No.
  • Yields are increasing because growth and inflation expectations are rising, combined with an uncertain regulatory backdrop adding fuel to an existing trend of higher interest rates.
  • The direction of interest rates (higher) is correct, but the speed is likely an overshoot, something similar to the 2009 decline in bond prices, uncoincidentally after the last major recession.
  • Maintaining an underweight stance on duration still makes sense. Bonds may find some help if regulators grant extensions to the SLR, but we should continue to expect the growth/inflation vector to favor equities and commodities rather than bonds and gold.

 

'Taper' Tantrum 2.0

 

Yields on longer-dated Treasury bonds rose with a speed that reminded market participants of the 2013 "taper tantrum." Bond yields rose sharply from 2012 to 2013, and the prevailing narrative was that a signal from the Federal Reserve that an end to QE was coming was responsible for the major decline in bond prices. 

In this note, we'll discuss why this narrative is misplaced, what actually caused the decline in bond prices during the 2012-2013 period, and what is causing the rapid rise in yields today. 

There are two opposing issues ongoing in the Treasury space.

First, due to unintended consequences of excessive Federal Reserve easing and a massive drawdown of the Treasury General Account "TGA," the front end of the Treasury curve continues to decline and will likely move into negative territory in the coming weeks. 

The issues at the front-end of the Treasury curve were discussed in prior research notes, one of which you can read here

Second, a combination of rising growth expectations, unrealistic expectations about future growth, and uncertain regulations are causing a rapid rise in long-term yields. 

Weekly Change In Treasury Rates:

Source: Bloomberg | To Expand, Right-Click > "Open Image In New Tab"

Over the last month, we see a similar picture in terms of the change in Treasury rates. The front-end of the yield curve continues to decline as an ocean of front-end liquidity is met with a scarcity of short-term high-quality assets while the long-end of the curve is spiking on a rebound in economic growth conditions. 

Monthly Change In Treasury Rates:

Source: Bloomberg | To Expand, Right-Click > "Open Image In New Tab"

The rise in bond yields this past week, which represents the bulk of the recent move, came entirely from the real interest rates, which are generally associated with changes in growth expectations, the risk premium, or liquidity conditions.  

Weekly Change In Treasury Rates Breakdown:

Source: Bloomberg| To Expand, Right-Click > "Open Image In New Tab"

The leading indicators have telegraphed the rise in growth expectations since the fall of last year, and the economic playbook has signaled an underweight allocation to long-term bonds is most prudent.

In this note, we'll discuss at length the current reasons for the movements in long-term bonds by analyzing the supposed 2013 "taper tantrum" and discounting the validity of that narrative and the applicability to today's situation.

Then, we'll highlight why this move in bond prices is much more similar to the 2009 episode in which long-term bond ETF (TLT) decline nearly 30% in less than six months. 

Lastly, we'll reiterate the regulatory uncertainty connected to the issues at the front end of the Treasury curve and how this is compounding the sell-off in long-term bonds. 

As a general theme of this note and EPB Macro Research in general, it should be noted that conventional wisdom places far too much focus on the Federal Reserve and the sideshow in Washington to explain fundamental moves in the Treasury bond market. We can nearly always turn to the fundamentals of growth and inflation for a more accurate explanation. As far as the current stance, the cyclical indicators are still pointing higher, which favors equities and commodities over bonds and gold. 
 

"Taper" Tantrum 2.0?

 

As noted in the chart below, since 2010, there have been five times TLT has declined roughly 15% in a three-month period. Also, the larger declines tend to come after large spikes, which held true during this current decline as TLT appreciated over 20% in the three-month period in 2020. 

3-Month Total Return: TLT

Source: YCharts | To Expand, Right-Click > "Open Image In New Tab"

Today's popular narrative is that the economy is performing so well due to fiscal stimulus that the Federal Reserve will be forced to taper its balance sheet and that the fear of tapering itself is the cause of the decline. 

First, the focus on the Federal Reserve and fiscal stimulus as the omnipotent force in markets are greatly exaggerated for reasons we will outline below. The majority of the multi-quarter or multi-year changes in interest rates and bond prices can be related to fundamental or cyclical shifts in growth and inflation. 

From the summer of 2012 through the summer of 2013, long-term bonds declined over 20%. 

The decline was ascribed to discussions at the Federal Reserve around tapering the existing Quantitative Easing "QE" program. This narrative does not hold once we study the underlying cyclical fundamentals at that time.

2013 Sell-Off: TLT

 Source: YCharts | To Expand, Right-Click > "Open Image In New Tab"
 
To start, from 2010 through 2012, the economic cycle was trending sharply lower. Interest rates declined, and the economy was in a fragile position. China began a large infrastructure stimulus which raised commodity prices globally and jumpstarted one of several global reflationary bouts we've seen since 2009. 

As we can see in the ECRI Weekly Leading Index chart, the growth rate surged from -8% to +8%. 

When cyclical leading indicators are pointing higher, interest rates rise. 

We should also note that the growth rate in the ECRI Weekly Leading Index started to trail off around the summer of 2013. It is critical to remember the most important factor is the vector or the direction in the growth rate of the cyclical leading indicators. 

ECRI Weekly Leading Index: Growth Rate

Source: ECRI | To Expand, Right-Click > "Open Image In New Tab"

Similarly, other cyclical indicators we track, such as the growth rate in the ISM prices paid index and the growth rate in the ratio of CRB metals to gold, displayed similar trends. The growth rate rose sharply through the early part of 2013, properly preceding the upturn in broad economic growth, before declining into the back half of 2013. 

Cyclical Leading Indicators:

Source: ECRI, ISM, CRB, YCharts | To Expand, Right-Click > "Open Image In New Tab"

How can we ascribe the entire move in interest rates to a simple discussion of "tapering" when cyclical leading indicators of growth were empirically rising rapidly in the first half of the year?

Unsurprisingly and consistent with the focus on cyclical fundamentals, as the growth rate peaked and started to decline in the back half of 2013, interest rates peaked, and bond prices (TLT) found a bottom before staging a nearly 30% rally. 

Both the decline in bond prices and the subsequent rally was highly consistent with the economic growth vector. 

TLT Total Return Price: Change (%)

Source: YCharts | To Expand, Right-Click > "Open Image In New Tab"

Most of the consensus narrative is not focused on economic cycles or cyclical shifts in the direction of growth and thus finds the most relevant and visceral story to explain the ongoing price movements. 

Furthermore, we know that changes in the Federal Reserve's balance sheet have almost nothing to do with changes in interest rates, at least in the direction that most believe. 

From December 2014 through August 2019, the Federal Reserve "tapered" their balance sheet in the most aggressive fashion since the start of QE after the Great Recession. 

Federal Reserve Balance Sheet:

Source: FRED | To Expand, Right-Click > "Open Image In New Tab"

Not only was the Federal Reserve "tapering" the balance sheet, but from December 2014 through August 2019, the Federal Reserve also raised short-term interest rates from 0.25% to 2.25%. 

The Federal Reserve tightened monetary policy in the most aggressive fashion seen since 2005-2006 from both the interest rate vector and the balance sheet vector. 

Surely, bond prices should have had a "tantrum" over this action.

From December 2014 through August 2019, long-term bond prices surged nearly 40%, proving that the Federal Reserve does not control the long-end of the Treasury curve and that monetary and fiscal action are not the main drivers. 

TLT Total Return During Balance Sheet Decline:

Source: YCharts | To Expand, Right-Click > "Open Image In New Tab"

To solidify this point, since August of 2020, the Federal Reserve has rapidly increased the size of its balance sheet, roughly $600 billion, and the result has been a rise in long-term bond yields. 

Fed Balance Sheet and 30-Year Rates:

Source: FRED | To Expand, Right-Click > "Open Image In New Tab"

Discussions of tapering the balance sheet or, conversely, discussions of increasing the size of QE have never resulted in the sustained impact on interest rates that it is believed to have. 

Rather, the most important factors driving the long-term and short-term trends in interest rates are the long-term and short-term trends in the direction of economic growth and inflation. 

 

Similarities to 2009

 

The recent move in interest rates and the economy are much more similar to 2009 for very clear and understandable reasons. 

In economics, there is a rule called the Zarnowitz Rule. 

The Zarnowitz Rule states that there is a historical pattern in which sharper recoveries follow sharper recessions. 

Now, this rule is only applicable to year one of a recovery, but massive, deep recessions should come with a very sharp snapback in year one of the recovery, regardless of fiscal stimulus or government intervention. 

We saw this play out perfectly as described in 2008-2009. 

Given that interest rates respond to changes in growth, bond prices react in the opposite fashion to the Zarnowitz Rule. 

Leading up to the 2008 crisis, bond prices surged on the pending collapse in economic growth, rising nearly 40% on the long-end of the curve. 

TLT During 2008: Total Return

Source: YCharts | To Expand, Right-Click > "Open Image In New Tab"

Subsequently, however, after surging 40%, bond prices crashed almost 30% as economic growth "snapped back" due to the Zarnowitz Rule. Bond prices declined nearly 30% in less than six months, similar to the decline witnessed today (not yet as extreme). 

TLT During 2009: Total Return (Zarnowitz Rule)

Source: YCharts | To Expand, Right-Click > "Open Image In New Tab"

The Zarnowitz rule can be seen clearly in the price of TLT in the massive surge and then sharp decline as economic growth exhibited the same characteristics. 

TLT During 2009: Total Return (Zarnowitz Rule)

Source: YCharts | To Expand, Right-Click > "Open Image In New Tab"

Did this mark the end of the multi-decade bond rally or change economic growth conditions for years to come? No, economic growth reverted back to the weak trend resulting from debt and demographics in year two of the recovery after the Zarnowitz Rule faded. 

We can see this trend very clearly, and the similarity to the 2008-2009 period in the chart of the ECRI Weekly Leading Index growth rate. Prior to the COVID crisis, the 2008 decline was the sharpest in modern history, leading to the sharpest recovery in modern history. The severity of the COVID decline outpaced the 2008 economic decline, and true to the rules of economics, the recovery is moving at a similar speed. 

ECRI Weekly Leading Index: Growth Rate

Source: ECRI | To Expand, Right-Click > "Open Image In New Tab"

The narrative in markets today is that it is the large fiscal stimulus that created this record recovery, but that is empirically not true, as we've outlined. The largest recovery in history would have come with or without fiscal stimulus simply due to the mechanisms behind pent-up demand recoveries. 

Of course, the fiscal stimulus did not hurt the short-term rebound, but it will weigh down the long-term recovery.

As a result of this narrative, market participants are convinced that fiscal stimulus is driving the speed of this recovery and that as long as fiscal stimulus continues, the recovery will continue at this current pace. 

Consensus will be surprised yet again when the Zarnowitz Rule fully plays out, which takes a proper full year recovery, and economic growth reverts to trend potential, inclusive of more fiscal stimulus. 

The long-term trends in bond prices will continue to reflect the long-term trends in the economy. 

TLT: Long-Term Total Return

Source: YCharts | To Expand, Right-Click > "Open Image In New Tab"

Cyclical leading indicators are pointing higher, and we should be very clear on this point. The economy still has the momentum to the upside from the Zarnowitz Rule and a manufacturing rebound, and interest rates should be rising in the short-term as a result. 

However, we should not conflate the speed of the year-one recovery to a new magical discovery of fiscal stimulus and a lasting vector of economic growth for years to come. 

As the recovery matures, growth will revert to the very weak, sub 2.0% trend due to a rapidly growing debt overhang and weakening demographics. 

 

Regulations Adding Fuel To The Fire

 

As noted in the prior two research notes on the unintended consequences at the front-end of the yield curve, there are regulatory changes that are creating more selling pressure on long-term bonds in addition to the Zarnowitz Rule and the cyclical momentum. 

To summarize, banks are regulated by various leverage ratios, including the "Supplemental Leverage Ratio" or "SLR."

The SLR measures a bank's tier 1 capital relative to its total leverage exposure, which includes on-balance-sheet assets (including Treasuries and reserves) and some off-balance sheet exposures. In April, during the height of the pandemic, regulators granted a temporary exclusion for Treasuries and reserves in this ratio, allowing banks to hold more Treasuries and reserve balances that hit the market in massive quantity through aggressive quantitative easing and fiscal stimulus. The exemption for Treasuries and reserves from the SLR calculation is set to expire on March 31, 2021.

In other words, banks are limited in terms of the size of their balance sheet, and all Treasuries and reserves count against this ratio. During the COVID crisis, there was an exemption that allowed bank balance sheets to grow as Treasuries and reserves were not counted against the SLR ratios.

With the exemption set to expire, bank balance sheets are way too big if Treasuries and reserves will now count against the SLR again. 

To make matters worse, due to the drawdown of the TGA, banks will be forced to take another trillion dollars in reserves and deposits despite their already bloated balance sheets. 

As a result, if the exemption expires, banks have to massively reduce the size of their balance sheets to get in line with the old SLR rules. 

If the SLR exemption is not extended, banks will have to reject new deposits, shed existing Treasury portfolios, or pull back on lending operations to reduce their balance sheet size.

With the TGA set to drawdown from ~$1.5T to $500B in the coming months, about $1T of new liquidity will hit the banking system in terms of reserves and deposits. 

Banks already have balance sheets that are too big to accept this new liquidity and get in line with the old SLR rules. 

The banks will reject these new deposits, which then likely flow to money market funds. Money market funds will not be able to accept $1T in new liquidity without driving the yields on Treasury bills deeply negative, nor will they be able to put all the new liquidity into over-night reverse repos at the Fed. 

With US banks unable to accept this liquidity and money market funds unable to accept this liquidity without consequences, the money may flow to foreign bank deposits that are not regulated strictly as US banks in terms of SLRs. 

The Fed has not signaled they will extend the SLR exemption so US banks and money market funds are likely in the process of trying to "make room" for some of the new front-end liquidity by unwinding portions of their balance sheet, which includes an abundance of Treasury bonds. 

Extending the SLR exemption for Treasury bonds and reserves would help reduce the additional "regulatory" selling pressure in the bond market that is occurring in addition to the economic fundamentals described above. 

 

Summary & Outlook

 

Bonds are reacting highly negatively for correct reasons, incorrect reasons, and regulatory issues. 

The economy remains in a cyclical upturn which should result in higher bond yields. The Zarnowitz Rule is also in full effect. 

However, the consensus is incorrectly extrapolating the year one recovery speed for years to come, which will prove untrue, regardless of fiscal stimulus. 

Uncertain changes regarding regulations are causing banks and money market funds to prepare for liquidity they cannot handle if we are to return to the old operating framework. 

The focus should remain on the economy's cyclical indicators, which suggest the preference should remain for stocks and commodities over bonds and gold, relative to your chosen baseline or benchmark allocation.

___________________________

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