Sat. May 28th, 2022

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Good morning. This week is stuffed with data drops and Federal Reserve speeches, which should make for some exciting, or exhausting, intraday price swings. Today we look at tumbling bonds, and take an overdue jaunt into crypto-land. Email us: and

Bond sell-off: Fed tightening or regime change?

The big story in markets remains the sell-off in bonds, instigated by the hard hawkish turn by the US Fed. Since March 1,

  • The 10 year Treasury yield has risen a dizzying 78 basis points, to 2.48 per cent.

  • The two year Treasury has risen by a whopping 98 basis points, to 2.28 per cent, leaving the 10/2 yield curve near inversion. Though the 10/2 curve is not nearly as good as the 10/3 month curve at forecasting recessions, it is almost as good at scaring people.

  • Five-year inflation break-evens have risen 45 basis points to 3.59 per cent.

  • Market expectations for Fed rate increases have shot up. The central forecast – weighted at a 65 per cent probability – is eight or nine 25bp increases by early 2023. A 50-point hike is widely expected at the May meeting.

The net result has been an absolute whipping for Treasuries relative to stocks:

Line chart of Per cent return showing Why do I own these things again?

As we have noted several times before, the return to a (relatively) normal rate environment was always going to be rocky, so it is important to keep things in perspective. That said, one does have to consider the ominous possibility that concerted Fed tightening might tip the market into recession. Don Rissmiller of Strategas gives a characteristically pithy summary: “The Fed is now likely in a ‘tighten until something breaks’ mode. The key question remains whether it’s inflation or growth that breaks first. ”

To put it another way, the US economy is running very hot right now, with jobless claims at a half-century low. But the Fed is tightening the screws at the same time as consumer sentiment is terrible, gas prices and mortgage rates are shooting up, and China’s key industrial cities face a growing Covid outbreak. All of these things are likely to hurt the economy at a lag, meaning they might bite just as the economy was starting to weaken anyway.

For now, the market is betting that the Fed will thread the needle, tightening enough to keep inflation under control without causing a recession. There are four indicators of this:

  • The 10/2 curve remains positive, and the more powerful prognosticator, the 10/3-month, is positively wide.

  • While corporate bond yields are rising, their spreads over Treasuries are still below pre-pandemic levels. If they were pricing in a higher risk of recession, you would expect more from junk spreads than this:

Line chart of ICE BofA US High Yield Index, Option-Adjusted Spread, per cent showing Panic this ain't
  • Stocks, though off their peaks, have rallied respectably in the last two weeks, and valuations are still higher than make sense if a recession is even a minor possibility any time soon.

This last point is a bit slippery. The Citigroup US equity strategy team points out that historically there has been little relationship between Fed policy direction and stock performance. Tightening hurts valuations, but tends to happen at periods when earnings are rising, and so the result is a wash:

Since the 70s, the correlation between fed funds changes, and S&P 500 returns have been virtually zero. The issue is the push-and-pull effect of the “P” (valuations), and “E” (earnings) drivers of markets. Fed tightening coincides with derating. S&P 500 P / E has shown a moderately negative correlation to fed funds changes over the long-term. Tighter policy usually drives investors to assign a lower “P” to index earnings. Rising fed funds align with better growth. The positive correlation of S&P 500 earnings growth to fed funds path is stronger than the negative valuation relationship. Lower multiples during Fed tightening are typically being applied to a rising “E”.

This sounds right, so far as it goes. But remember the usual pattern these things fall into. In one part of the cycle, the economy is hot, earnings rise, stocks do well, and the Fed tightens. In the next part, the Fed sees signs of economic cooling, coinciding with earnings growth slowing, and stops tightening. It’s the third phase that causes the trouble: the economy and earnings continue to slow, the Fed starts to cut. . . but it is too late, and a recession follows. Sometimes (as in the early-mid 90s) this third phase never occurs. But often it does.

So, yes, there have been several instances, as Citi highlights, where Fed tightening has coincided with rising stocks. What matters most to investors, though, is whether a recession follows, and if so how quickly; recessions are awful for stocks. Here is Citi’s chart of year-over-year change in the S&P and the Fed funds rates. The gray bars are recessions. Unhedged has added our usual tidy circles around moments of simultaneous rises in rates and stocks.

Stocks, in short, sometimes get the recession memo rather late. Still, even if stocks’ current strength is only a modest comfort, the yield curve and bond spreads remain significantly reassuring.

But what if something bigger than the standard interplay between rates and the business cycle is going on? Bank of America’s Michael Hartnett thinks the bond sell-off is not just about Fed tightening. It is also a sign of regime change. He lays out his case in clipped style:

2020 secular low markets for inflation & yields – third great bear bond market under way; prior great bears were 1899 to 1920 and 1946 to 1981; deflation to inflation, globalization to isolationism, monetary to fiscal excess, capitalism to populism, inequality to inclusion, US dollar debasement. . . long-term yields> 4 per cent by ’24.

> +10 per cent from stocks & bonds of recent decades likely to fall to <3-5 per cent long-run returns at best; higher volatility in bonds, currencies & stocks.

while the “geography of capital” favors US stocks near-term (investors grappling with a shrinking geographical opportunity set as countries & asset classes to invest in confidence of safety & liquidity), tech is the new secular sell-into-strength (likely worst performing sector of 2020s) as bond yields rise over the medium-term & central bank liquidity shrinks

The two historical bear markets Hartnett alludes to are easy to see on this chart:

This is what is known as a great big call, and we are not sure how we feel about it. Hartnett is not alone in thinking that the deflationary forces that defined the last four decades, and which we might loosely group under the heading “globalization,” are fading fast. Charles Goodhart and Nouriel Roubini, to name just two, have broadly similar views.

We find these outlooks, which call for a long bear market in bonds, a little hard to square with the idea (with which we agree) that the economy’s underlying interest rate (“R star”) continues to fall. A lower R-star implies the Fed can only hike so far, which puts a cap on yields, too. But there is a lot to think about here. (Armstrong & Wu)

Ethereum and energy

Crypto has, at a minimum, a bad brand. Associations with speculation and fraud are baked in. Worse, issuing most cryptocurrencies is an energy-intensive process. A common conclusion: using greenhouse gas emitting energy to create an instrument for fraud and speculation is a bad idea.

Fraud and speculation aside, a long-awaited solution to ethereum’s high energy consumption is set to roll out in the next few months (though it’s been delayed before). The basic idea is to overhaul how new ethereum is minted. A mostly successful beta test on March 15 led to a week of ethereum outperforming bitcoin.

Where the current system asks “miners” to devote heavy computational power, the proposed new system would instead have “stakers” post their tokens as collateral in exchange for a yield. The result of moving to “proof of stake” would be cutting the network’s electricity consumption by orders of magnitude.

A successful switch for ethereum would be embarrassing for bitcoin. Since the two coins make up over 60 per cent of all crypto market cap, crypto’s energy problem would become chiefly bitcoin’s. So bitcoiners have gone on the attack. Ethereum’s new system, they say, hurts decentralization.

Ethereum production under proof of stake would empower the richest ethereum holders, the argument goes. Stakers need to lock up a minimum of 32 ethereum, worth $ 105,000 at current exchange rates. And while some side applications exist to let smaller fish stake (and earn yield), control would be heavily concentrated among the whales.

I think this criticism is correct, but might not matter. Crypto’s role in funnelling donations to Ukraine has launched the sector to new heights, even earning an approving nod from BlackRock’s Larry Fink last week. Crypto’s break into mainstream finance, whatever it might look like, may be getting closer. But mainstream finance is not an industry bothered by concentration at the top. In strict business terms, Ethereum’s choice of energy efficiency over decentralization seems smart. (Ethan Wu)

One good read

A nice piece from our colleague Brooke Masters on asset managers headlong rush into “alternative investments”. The explanation for the trend is that “alts” bring in higher fees. Whether they bring in higher performance or genuine diversification remains to be seen.

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