It's the bond market

March 19, 2021

4:21 pm

It's the bond market
  • As much as YOLO-type acronyms and fist-bump emojis are fun, when apprising asset classes, the more helpful points of reference are the prosaic underpinnings of modern financial markets, such as the US bond market and dollar. The world’s reserve currency lies at the heart of global financial system, which is based on debt and leverage. When one is taking a macro view of financial markets, the starting point is always the dollar and in particular two questions; how much does it cost and how many are there relative to demand? When the dollar is outperforming other currencies and US Treasury yields are rising, the answer to these questions is too much and not enough respectively. And because you only live once, it’s worth paying attention.

  • The graph below illustrates the trend clearly, with the 10yr Treasury in yellow and the DXY US Dollar Index in blue. The rise in Treasury yields in 2021 is particularly pronounced. From January 1st (vertical red line), the 10yr yield has risen around 70bps to 1.60%. Why is this all happening and what, if anything, will change these trends?
Graph

Source: Bloomberg, March 2021. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • For the purposes of analysis, the yield curve can be split into roughly two parts. The short end (5yrs and less) tends to reflect central bank interest-rate policy and market-liquidity technicals, especially at the very short end. Further out along the curve (10yr and beyond), the main driver is economic growth (GDP) and inflation expectations. At present, there are things going on both at the short end and the long end, both of which need to be examined.

  • Starting at the short end, the US Treasury is running down its reserve balance at the Fed. This balance is called the Treasury General Account (TGA), and during a period of prolific bill issuance during 2020, this rose to a record $1.8t. Secretary of the Treasury Janet Yellen has announced that this balance will be run down to more normal levels through to June, with numbers estimated around $800bn in terms of the size of the reduction.

  • The spike and subsequent reduction TGA balance can be seen in the graph below, courtesy of St Louis Federal Reserve data. There are two potential consequences. First, that the Treasury is going to spend a large amount of money without issuing bonds, even as the Fed continues quantitative easing (QE). All else equal, this would be inflationary – the Treasury raised money last year, but didn’t actually spend it.
Graph
Source: Board of Governors; St Louis Fed, 31st December 2020.
  • From the point of view of the banking system, as the Treasury spends money, so do bank reserves rise – spent money ends up in the bank, and this is where the liquidity problems start. Drawing down the TGA at the Fed means it is not issuing T-bills in the volume it used to. T-Bills are the most pristine form of collateral in the repo market (the cost of sale-and-repurchase agreements or repos depends in part on collateral quality, and short-dated US Treasury bills are top of that list), so when the Treasury issues fewer bills, the repo market tightens up as the stock of good-quality collateral goes down, raising the cost of financing. Fewer dollars, and more expensive – the dollar goes up (see the DXY graph above).

  • But the knock-on effect of repo tightness extends out along the yield curve too. The current 10yr on-the-run Treasury note has traded a low as -4% in the repo market, showing that there is tightness further out. This may in part be driven by a desire to short treasuries on rising inflation expectations, but there is another more prominent reason.

  • Back in April 2020, the Fed suspended the SLR (supplementary lending ratio). The SLR was introduced in 2010 in the Dodd-Frank legislation to make sure banks were better capitalised. Basically, it meant that, amongst others, the big banks (G-SIBS or globally-significant investment banks like JP Morgan and Citi) had to hold at least 3% more collateral against their lending going forward, and this reserve would have to rise the bigger their balance sheets grew. With the flood of Treasury issuance after the pandemic (to pay for the fiscal response), these rules were suspended, allowing banks to load up their balance sheets to absorb the increased Treasury supply. The exemption ends on the 31st March, and it is unclear whether it will be rolled over. This is a decision for the Fed, but there is clearly political pressure at work here too, notably from Senator Elizabeth Warren (Dem) who has been vocal in calling for the SLR exemption to be ended.

  • A return to the old SLR rules would mean banks having to reduce their balance sheets by shedding deposits and owning fewer Treasuries. Not only does this tighten lending, it means less leverage for geared market participants like hedge funds, hence the market sell-off. It also means less demand in Treasury auctions, which, all else equal, leads to higher yields. This is turning into quite a cocktail.

  • If that wasn’t enough, not only is Treasury issuance rising (an extra $1tn in 2021 and counting), but inflation expectations are rising, and this puts pressure on the long end of the Treasury curve. The graph below shows 5yr US TIPS inflation Treasury break-evens. Currently this stands at 2.5%, and the period from March through to June is likely to see a dramatic increase in headline inflation due to so-called base effects as current prices are compared to the depressed ones of a year ago (remember when oil was trading in the negative $30s in April 2020?). Add in a rapidly rising oil price due to OPEC not agreeing to increase production and an attack on Saudi Aramco’s refineries, then you get quite a push to short-term inflation pressures, and this in turn pushes nominal bond yields higher.
Graph
Source: Bloomberg, March 2021.
  • The bit equity markets (especially growth-orientated indices like the Nasdaq) really don’t like is real rates rising. In 2021, 10yr US Treasury real rates have risen from -1.09% to -0.64%. All else equal, the perceived discount factor of equity cash flows falls, dragging stock prices lower. Add in tighter financing conditions and banks possibly having to deleverage due to the SLR restrictions, then hedge-fund leverage comes down, further exacerbating the problem. The combination of tighter liquidity, growing Treasury supply and rising inflation expectations is a very difficult trifecta for the market to deal with.

  • Who normally rides to the rescue when the market isn’t going up every day? You got it, the Fed. But at a Q&A with the Wall Street Journal on the 4th March when Fed Chairman Jay Powell was asked about all of this (inflation, SLR, liquidity, the stock market), his reply was that they monitored many data points but as it stood, financial conditions were still easy and there would be no imminent action. The markets took fright – the dollar rose, equities sold off, bond yields rose.

  • The problem is the Fed is now in a blackout period ahead of the FOMC meeting on the 17th The market is effectively on its own, and it doesn’t like that. The market also now knows that it needs ‘an event’ to force the Fed to intervene. As it stands, a 10% or so fall in the Nasdaq is not enough. Given Powell’s reference to financial conditions, one suspects that a blow out in the credit market might do it. As the graph below of the CDX IG (investment grade) US credit default swap index shows, credit spreads are currently benign even though the equity market is looking increasingly traumatised. The current spread is around 54 versus a March 2020 crisis high of over 140.
Graph
Source: Bloomberg, March 2021.
  • There are a number of things the Fed could do. It could extend the SLR exemption, allowing banks to keep bigger balance sheets. This would ease repo issues and create a bid for Treasuries. They could do a ‘twist’ in QE, selling short-dated Bills to buy longer-dates 10yr and 30yr bonds (easing the repo collateral issue and putting a lid on long-term real rates, weakening the dollar). The game changer would be yield curve control, where rates are capped at a pre-announced level. One senses though the Fed is a reactive not a proactive organisation, so we need a proper market crisis for them to act. Suddenly it’s a very long time until the 17th March when Powell next speaks, and it’s worth noting that more often than not when he does actually speak, the market tanks. Time to stay frosty.
Unless otherwise stated, all opinions within this document are those of the RWC Diversified Return Investment Team, as at 10th March 2021.

The term “RWC” may include any one or more RWC branded entities including RWC Partners Limited and RWC Asset Management LLP, each of which is authorised and regulated by the UK Financial Conduct Authority and, in the case of RWC Asset Management LLP, the US Securities and Exchange Commission; RWC Asset Advisors (US) LLC, which is registered with the US Securities and Exchange Commission; and RWC Singapore (Pte) Limited, which is licensed as a Licensed Fund Management Company by the Monetary Authority of Singapore.


RWC may act as investment manager or adviser, or otherwise provide services, to more than one product pursuing a similar investment strategy or focus to the product detailed in this document. RWC seeks to minimise any conflicts of interest, and endeavours to act at all times in accordance with its legal and regulatory obligations as well as its own policies and codes of conduct.

This document is directed only at professional, institutional, wholesale or qualified investors. The services provided by RWC are available only to such persons. It is not intended for distribution to and should not be relied on by any person who would qualify as a retail or individual investor in any jurisdiction or for distribution to, or use by, any person or entity in any jurisdiction where such distribution or use would be contrary to local law or regulation.


This document has been prepared for general information purposes only and has not been delivered for registration in any jurisdiction nor has its content been reviewed or approved by any regulatory authority in any jurisdiction. The information contained herein does not constitute: (i) a binding legal agreement; (ii) legal, regulatory, tax, accounting or other advice; (iii) an offer, recommendation or solicitation to buy or sell shares in any fund, security, commodity, financial instrument or derivative linked to, or otherwise included in a portfolio managed or advised by RWC; or (iv) an offer to enter into any other transaction whatsoever (each a “Transaction”). No representations and/or warranties are made that the information contained herein is either up to date and/or accurate and is not intended to be used or relied upon by any counterparty, investor or any other third party.


RWC uses information from third party vendors, such as statistical and other data, that it believes to be reliable. However, the accuracy of this data, which may be used to calculate results or otherwise compile data that finds its way over time into RWC research data stored on its systems, is not guaranteed. If such information is not accurate, some of the conclusions reached or statements made may be adversely affected. RWC bears no responsibility for your investment research and/or investment decisions and you should consult your own lawyer, accountant, tax adviser or other professional adviser before entering into any Transaction. Any opinion expressed herein, which may be subjective in nature, may not be shared by all directors, officers, employees, or representatives of RWC and may be subject to change without notice. RWC is not liable for any decisions made or actions or inactions taken by you or others based on the contents of this document and neither RWC nor any of its directors, officers, employees, or representatives (including affiliates) accepts any liability whatsoever for any errors and/or omissions or for any direct, indirect, special, incidental, or consequential loss, damages, or expenses of any kind howsoever arising from the use of, or reliance on, any information contained herein.


Information contained in this document should not be viewed as indicative of future results. Past performance of any Transaction is not indicative of future results. The value of investments can go down as well as up. Certain assumptions and forward looking statements may have been made either for modelling purposes, to simplify the presentation and/or calculation of any projections or estimates contained herein and RWC does not represent that that any such assumptions or statements will reflect actual future events or that all assumptions have been considered or stated. Forward-looking statements are inherently uncertain, and changing factors such as those affecting the markets generally, or those affecting particular industries or issuers, may cause results to differ from those discussed. Accordingly, there can be no assurance that estimated returns or projections will be realised or that actual returns or performance results will not materially differ from those estimated herein. Some of the information contained in this document may be aggregated data of Transactions executed by RWC that has been compiled so as not to identify the underlying Transactions of any particular customer.


The information transmitted is intended only for the person or entity to which it has been given and may contain confidential and/or privileged material. In accepting receipt of the information transmitted you agree that you and/or your affiliates, partners, directors, officers and employees, as applicable, will keep all information strictly confidential. Any review, retransmission, dissemination or other use of, or taking of any action in reliance upon, this information is prohibited. The information contained herein is confidential and is intended for the exclusive use of the intended recipient(s) to which this document has been provided. Any distribution or reproduction of this document is not authorised and is prohibited without the express written consent of RWC or any of its affiliates.

Changes in rates of exchange may cause the value of such investments to fluctuate. An investor may not be able to get back the amount invested and the loss on realisation may be very high and could result in a substantial or complete loss of the investment. In addition, an investor who realises their investment in a RWC-managed fund after a short period may not realise the amount originally invested as a result of charges made on the issue and/or redemption of such investment. The value of such interests for the purposes of purchases may differ from their value for the purpose of redemptions. No representations or warranties of any kind are intended or should be inferred with respect to the economic return from, or the tax consequences of, an investment in a RWC-managed fund. Current tax levels and reliefs may change. Depending on individual circumstances, this may affect investment returns. Nothing in this document constitutes advice on the merits of buying or selling a particular investment. This document expresses no views as to the suitability or appropriateness of the fund or any other investments described herein to the individual circumstances of any recipient.


AIFMD and Distribution in the European Economic Area (“EEA”)


The Alternative Fund Managers Directive (Directive 2011/61/EU) (“AIFMD”) is a regulatory regime which came into full effect in the EEA on 22 July 2014. RWC Asset Management LLP is an Alternative Investment Fund Manager (an “AIFM”) to certain funds managed by it (each an “AIF”). The AIFM is required to make available to investors certain prescribed information prior to their investment in an AIF. The majority of the prescribed information is contained in the latest Offering Document of the AIF. The remainder of the prescribed information is contained in the relevant AIF’s annual report and accounts. All of the information is provided in accordance with the AIFMD.


In relation to each member state of the EEA (each a “Member State”), this document may only be distributed and shares in a RWC fund (“Shares”) may only be offered and placed to the extent that (a) the relevant RWC fund is permitted to be marketed to professional investors in accordance with the AIFMD (as implemented into the local law/regulation of the relevant Member State); or (b) this document may otherwise be lawfully distributed and the Shares may lawfully offered or placed in that Member State (including at the initiative of the investor).


Information Required for Distribution of Foreign Collective Investment Schemes to Qualified Investors in Switzerland


The representative and paying agent of the RWC-managed funds in Switzerland (the “Representative in Switzerland”) is Société Générale, Paris, Zurich Branch, Talacker 50,

P.O. Box 5070, CH-8021 Zurich. In respect of the units of the RWC-managed funds distributed in Switzerland, the place of performance and jurisdiction is at the registered office of the Representative in Switzerland.

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The term “RWC” may include any one or more RWC branded entities including RWC Partners Limited and RWC Asset Management LLP, each of which is authorised and regulated by the UK Financial Conduct Authority and, in the case of RWC Asset Management LLP, the US Securities and Exchange Commission; RWC Asset Advisors (US) LLC, which is registered with the US Securities and Exchange Commission; and RWC Singapore (Pte) Limited, which is licensed as a Licensed Fund Management Company by the Monetary Authority of Singapore.

RWC may act as investment manager or adviser, or otherwise provide services, to more than one product pursuing a similar investment strategy or focus to the product detailed in this document. RWC seeks to minimise any conflicts of interest, and endeavours to act at all times in accordance with its legal and regulatory obligations as well as its own policies and codes of conduct.

This document is directed only at professional, institutional, wholesale or qualified investors. The services provided by RWC are available only to such persons. It is not intended for distribution to and should not be relied on by any person who would qualify as a retail or individual investor in any jurisdiction or for distribution to, or use by, any person or entity in any jurisdiction where such distribution or use would be contrary to local law or regulation.

This document has been prepared for general information purposes only and has not been delivered for registration in any jurisdiction nor has its content been reviewed or approved by any regulatory authority in any jurisdiction. The information contained herein does not constitute: (i) a binding legal agreement; (ii) legal, regulatory, tax, accounting or other advice; (iii) an offer, recommendation or solicitation to buy or sell shares in any fund, security, commodity, financial instrument or derivative linked to, or otherwise included in a portfolio managed or advised by RWC; or (iv) an offer to enter into any other transaction whatsoever (each a “Transaction”). No representations and/or warranties are made that the information contained herein is either up to date and/or accurate and is not intended to be used or relied upon by any counterparty, investor or any other third party.

RWC uses information from third party vendors, such as statistical and other data, that it believes to be reliable. However, the accuracy of this data, which may be used to calculate results or otherwise compile data that finds its way over time into RWC research data stored on its systems, is not guaranteed. If such information is not accurate, some of the conclusions reached or statements made may be adversely affected. RWC bears no responsibility for your investment research and/or investment decisions and you should consult your own lawyer, accountant, tax adviser or other professional adviser before entering into any Transaction. Any opinion expressed herein, which may be subjective in nature, may not be shared by all directors, officers, employees, or representatives of RWC and may be subject to change without notice. RWC is not liable for any decisions made or actions or inactions taken by you or others based on the contents of this document and neither RWC nor any of its directors, officers, employees, or representatives (including affiliates) accepts any liability whatsoever for any errors and/or omissions or for any direct, indirect, special, incidental, or consequential loss, damages, or expenses of any kind howsoever arising from the use of, or reliance on, any information contained herein.

Information contained in this document should not be viewed as indicative of future results. Past performance of any Transaction is not indicative of future results. The value of investments can go down as well as up. Certain assumptions and forward looking statements may have been made either for modelling purposes, to simplify the presentation and/or calculation of any projections or estimates contained herein and RWC does not represent that that any such assumptions or statements will reflect actual future events or that all assumptions have been considered or stated. Forward-looking statements are inherently uncertain, and changing factors such as those affecting the markets generally, or those affecting particular industries or issuers, may cause results to differ from those discussed. Accordingly, there can be no assurance that estimated returns or projections will be realised or that actual returns or performance results will not materially differ from those estimated herein. Some of the information contained in this document may be aggregated data of Transactions executed by RWC that has been compiled so as not to identify the underlying Transactions of any particular customer.

The information transmitted is intended only for the person or entity to which it has been given and may contain confidential and/or privileged material. In accepting receipt of the information transmitted you agree that you and/or your affiliates, partners, directors, officers and employees, as applicable, will keep all information strictly confidential. Any review, retransmission, dissemination or other use of, or taking of any action in reliance upon, this information is prohibited. The information contained herein is confidential and is intended for the exclusive use of the intended recipient(s) to which this document has been provided. Any distribution or reproduction of this document is not authorised and is prohibited without the express written consent of RWC or any of its affiliates.

Changes in rates of exchange may cause the value of such investments to fluctuate. An investor may not be able to get back the amount invested and the loss on realisation may be very high and could result in a substantial or complete loss of the investment. In addition, an investor who realises their investment in a RWC-managed fund after a short period may not realise the amount originally invested as a result of charges made on the issue and/or redemption of such investment. The value of such interests for the purposes of purchases may differ from their value for the purpose of redemptions. No representations or warranties of any kind are intended or should be inferred with respect to the economic return from, or the tax consequences of, an investment in a RWC-managed fund. Current tax levels and reliefs may change. Depending on individual circumstances, this may affect investment returns. Nothing in this document constitutes advice on the merits of buying or selling a particular investment. This document expresses no views as to the suitability or appropriateness of the fund or any other investments described herein to the individual circumstances of any recipient.

AIFMD and Distribution in the European Economic Area (“EEA”)

The Alternative Fund Managers Directive (Directive 2011/61/EU) (“AIFMD”) is a regulatory regime which came into full effect in the EEA on 22 July 2014. RWC Asset Management LLP is an Alternative Investment Fund Manager (an “AIFM”) to certain funds managed by it (each an “AIF”). The AIFM is required to make available to investors certain prescribed information prior to their investment in an AIF. The majority of the prescribed information is contained in the latest Offering Document of the AIF. The remainder of the prescribed information is contained in the relevant AIF’s annual report and accounts. All of the information is provided in accordance with the AIFMD.

In relation to each member state of the EEA (each a “Member State”), this document may only be distributed and shares in a RWC fund (“Shares”) may only be offered and placed to the extent that (a) the relevant RWC fund is permitted to be marketed to professional investors in accordance with the AIFMD (as implemented into the local law/regulation of the relevant Member State); or (b) this document may otherwise be lawfully distributed and the Shares may lawfully offered or placed in that Member State (including at the initiative of the investor).

Information Required for Distribution of Foreign Collective Investment Schemes to Qualified Investors in Switzerland

The representative and paying agent of the RWC-managed funds in Switzerland (the “Representative in Switzerland”) FIRST INDEPENDENT FUND SERVICES LTD, Klausstrasse 33, CH-8008 Zurich. Swiss Paying Agent: Helvetische Bank AG, Seefeldstrasse 215, CH-8008 Zurich. In respect of the units of the RWC-managed funds distributed in Switzerland, the place of performance and jurisdiction is at the registered office of the Representative in Switzerland.

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