The “policy mistake” mistake

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Welcome back. I hope your Halloween is spooky, and that this week is not. Earnings continue, and tonnes of economic data will land, including the ISM manufacturing index this morning and October payrolls on Friday. Hold on tight.

The “policy mistake” mistake

Things have been pretty wild in bond markets recently. Here is a chart of the changes in Treasury yields of various maturities over the past 10 days:

Short- and mid-duration bonds have sold off, increasing their yields, and long term bond have done the opposite, resulting in a remarkably sharp flattening of the curve. Many observers have concluded that the market is anticipating a hawkish policy mistake. The idea is that central banks have suddenly woken up to inflation, and will tighten policy so aggressively that they hurt long-term growth, driving short rates up and long ones down.

This story makes sense, even in the absence of much new news from the Fed, given that last week the central banks of Canada and Australia made hawkish policy announcements, and ECB president Christine Lagarde adopted sterner language about inflation. All this fits the pattern set in September and October, when the Bank of England and the Bank of New Zealand made tightening noises.

But bond strategists and investors I spoke to Friday told a different story. Many of them think the market has overreacted. Jim Caron, chief fixed-income strategist at Morgan Stanley Investment Management, said that

Clearly there has been an inflation surprise to the upside and developed markets central banks have been responding more hawkishly as a result. One thing the yield curve is telling me is that if central banks tighten too much too soon, it will be a policy mistake. That’s why the back end is lower.

At the same time, though, Caron thinks that investors, who had all been sitting on one side of the boat, have now rushed to the other side. A curve that was too steep may be too flat now.

A lot of forecasters have gotten inflation wrong . . . [but] now the forecasters have a tailwind. We know the supply shocks are starting to alleviate, though not as fast as we want, and the [inflation] comparables will get easier . . . 

Consensus PCE [personal consumption expenditures] estimate for the fourth quarter is 4.2 per cent, and for the first quarter is 4.1 per cent. But for the second quarter we are looking for 2.3 because you lap the reopening . . . If you are at the Fed or ECB, you are thinking, ‘if we overreact to a supply shock that is dispersing [we’ll regret it]’

We’ve been fortunate to be in a [yield curve] flattener [trade] and we are taking that position off and we’re entering steepeners at these levels . . . the structural dynamics become easier for inflation to go down in 2022 . . . I don’t want to oversell it, shortages and all these things will be there, but I think the market has overshot on inflation being continually bad for the next 12 months .

Tapering bolsters this view because, if the Fed stops buying bonds that helps the curve steepen 

Bob Michele, head of fixed income at JPMorgan asset management, agrees. Central banks are waking up to inflation, and that has rightly jarred the market, but the policy mistake narrative has been oversold:

The view that central banks were brain-dead with respect to the real world, saying inflation was transitory, has proved to be correct. People sitting on yield curve steepened [trades] have scrambled to cover . . . they believed the Fed and other banks would be true to their word, would be behind the curve, and would delay raising rates until 2023 at least . . . 

There were lot of levered positions sat on short end [and they are being unwound]

But yields, even at the long end, should continue to march upwards:

The [falling] long end [or the curve] is investors looking for a narrative, people thinking that central banks’ moves will choke off growth . . . I don’t buy any of it, there is plenty of growth, plenty of stimulus, plenty of inflation to push up yields all across the yield curve

Michele anticipates two rate increases in 2022. He expects the Fed to start tapering bond purchases in November, at a rate of $15bn a month. That will bring the rate of new purchases to zero by June. While the Fed would have liked to wait several quarters after that to start raising rates “they won’t have that luxury.” Sub-zero real yields will look extravagantly wrong by then.

BlackRock’s fixed income CIO, Rick Rieder, agrees that there is enough juice in the economy to push the back end of the curve up again, despite the shadow of tightening coming sooner than many expected:

The US economy is very strong, consumer demand is strong, corporate demand is strong. There is not enough supply — all the data we got [Friday], all the earning releases confirmed that . . . rates can move higher from here, [though] most of the work on the front end has been done

Greg Peters, head of fixed income multi-sector and strategy at PGIM, argues that the market overshoot may not have played itself out yet, because liquidity in the Treasury market is so thin:

[there has been] a massive revisitation by global central banks around removing accommodation, all these leveraged positions hinged off that [accommodation], and the microstructure of the market is so broken you have a herd of elephants moving through a small door. Weird things happen; what is rich gets richer and what is cheap gets cheaper — for example, the 20 year gets 5 basis points cheaper than the 30 year.

The truth is there is a decent amount that hasn’t been unwound yet; this could go on .

Not everyone agrees with the view that bond markets have overshot in the past few weeks. Edward Al-Hussainy, rates strategist at Columbia Threadneedle, discounts the idea that recent actions of international central banks have spooked Treasury investors. Countries like Canada, Australia and New Zealand are leveraged to the surging commodities cycle and have been signalling a tighter policy path for a while. For the US what has really driven change is what the Federal Reserve communicated at its meeting back on September 21:

Everyone was expecting the Fed to give us some indication or some new language about separating the taper from interest hikes. But [language about] the wedge between the taper and the hike was lukewarm, especially in the news conference, and the perception was that the Fed were no longer confident in inflation being transitory . . . [Jay Powell] had an opportunity to use stronger language, and he didn’t 

As evidence, Al-Hussainy points to Eurodollar spreads, which reflect the anticipated interest rate on international US dollar deposit accounts, a proxy for future Fed policy rates. Shorter- and longer-term spreads started to diverge immediately after the September meeting, signalling that from the middle of next year to the end of 2023 (the blue line in the Bloomberg chart below) more rate rises were likely. But after 2023 (the red line), the market is anticipating perhaps one more hike. The market sees “a spurt of inflation and a spurt of tightening and then in a flash we are done” because growth and inflation subside. Hence the short end and belly of the yield curve rising and the long end falling.

Intentionally or not, the Fed left the door open to tightening starting in the middle of next year, a shift in policy took the markets over a month to fully digest.

Tesla towers over the options market

Far and away the most traded equity options are those based on the S&P 500 index and on the ETF based on that index. The nominal outstanding value of those options is currently over $7bn. Here are the next-largest indices and individual stocks by notional option volume (the data comes from OptionMetrics): 

There is almost twice as much outstanding volume of Tesla options than there are of Nasdaq index options, and more volume in Tesla than in the next three biggest individual names (Amazon, Apple and Facebook) combined. This strikes me as wild. Here is a chart (OptionMetrics data again) of how Tesla Option volumes have grown over time:

I’m not sure I have a tonne to say about this, other than “holy crow.” But the numbers do suggest that moves in Tesla’s stock price might be heavily influenced by market makers, who have to hedge their option exposure by buying or selling the underlying shares. The numbers also suggest investor interest in Tesla has a highly speculative flavour. For example, Apple has 2.4 times the market cap of Tesla, but a fifth of Tesla’s option volume.

We know this already, but wow, does Tesla attract risk seekers.

One good read

If you read statistical studies, you will have run across the notion that some results are “statistically significant” and others are not, or talk about “statistically significant differences.” This piece from Nature neatly expresses the increasingly popular view that statistical significance is a useless concept which encourages junk science.

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