What's the yield curve telling us?
Paid subscriber analysis
Things are heating up. Two more weeks left until the election (Nov 5th) and the next FOMC (Nov 7th). In the meantime we are getting 5 out of 7 Mag7 earnings. TSLA was this week - beat, went up a whopping 21% on Thursday alone! - NVDA is in a month from now, and the rest (GOOGL, MSFT, AMZN, META, APPL) are lined up from Tue to Thu. Plus on Wednesday we get the new QRA report from the Treasury. Fun packed week!
Earnings are key, as we mentioned last week, and in light of the current expensive vol environment + window of weakness, we are more likely to get a jumpy market depending on the results. Very similar to this week, with down-up on Mon, Tue, Thu, a sell on Wed, and a rally + reversal on Fri. Jumpy 🦘. We are also witnessing the rise of the USD, highly correlated to the market pricing in a Trump victory. More on this next time.
And finally, there is interesting price action happening on the bond market. The last two QRA reports from the Treasury (where the Treasury decides the supply of new bonds) failed to move markets as they have throughout 2023. Nevertheless it will be interesting to keep an eye on the one coming up on Wed.
Today we dig into this, trying to explain why the yield curve is steepening - in other words, why are yields going up (>4.2% on the 10Y, >4% on the 2Y) despite the 50bps in cuts and further 75bps expected before the end of the year.
Next week we will present our playbook for the elections and FOMC. So make sure to subscribe not to miss these two important pieces:
Why is the yield curve steepening?
After the Fed cut rates by 50bps and announced in their September summary of economic projections at least two more cuts before the end of the year, plus a schedule of cuts that would push rates down to 3.5% by the end of 2025, it was widely expected that we would see bond yields coming down as well. After all, the two move in unison, where the 2Y yield typically has a predictive element, as it anticipates the Fed rate moves.
But yields went up since the FOMC meeting on Sep 18th. The 10Y went from 3.6% to 4.2% in just one month (14% growth) The 2Y made an 11.5% jump in the same period, see chart below. This obviously affected the 30-year mortgage rate, which is back above 7%. Bond markets are trading as if inflation is about to escalate once again and the Fed will raise rates, not cut them.
And here we are talking about a soft landing, where the Fed will push inflation back to target without triggering a spike in unemployment or an economic slowdown. This has been the key narrative feeding the market the past 2 years. But the bond market is apparently challenging this narrative, and leaning towards the opposite one - that the Fed was wrong to cut 50bps in September. Or is it?
In general it all still depends on the (backwards looking) economic data. If inflation spikes up again, and if the labor market starts to dwindle, we are back in the dreaded stagflation scenario. In other words we get a repeat of the 1970s, where the first wave of inflation came down, only to be replaced by an even worse second wave.
How likely is this to happen this time? In my opinion, unlikely. However, a resurgence of inflation hasn’t been priced in at all in the equity markets, which makes it a potential danger for long-only investors.
Just look at bonds compared to other assets since September 18th. As bonds sold off, gold went up over 6.5%, SPX 3.7%, NDX 5.5%. Quite the gap there. Gold is, btw, replacing bonds as an apt equities hedge. All these long-only investors are piling up gold to serve as protection in case of a recession, which is why gold is up over 30% in the past year.
But this doesn’t explain why bonds are selling off.
Several possible reasons why this is happening:
Investors pricing in a Trump victory - this translates into higher inflation expectations (due to tariffs and larger budget deficits), but also higher nominal growth expectations. With current GDPNow being at 3.3%, and with expectations of Trump being even more stimulative for growth, it’s no wonder investors are pricing in higher bond yields and anticipating the Fed won’t be cutting as much, or could even pause or (God forbid!) hike.
Hotter than expected labor market data from that last report on Oct 4th was another signal that the economy is getting hotter, not slowing down at all. This in particular was the main trigger for yields shooting up on the day (see first chart above).