Quantifying Treasuries' Upside In A Recession

"But, but, but, rates have nowhere to go but higher..." is all we have heard for the past year.

But what if that is incorrect?

KesslerCompanies.com quanitifies the upside returns from owning bonds if things don"t work out as ebuliently as expected...

It is only logical to assume that after 8.2 years of unimpeded GDP expansion in the US, we are near to the other side of the business cycle, a recession. The average expansion since 1900 is 3.8 years, and this one is already the 3rd longest, only bested by an expansion in the 60’s at 8.8 years and the expansion in the ‘Roaring 90’s’ at 10 years.

Logically and empirically, recessions see much lower interest rates. Cycles associated with the 14 recessions since and including the Great Depression average a drop of 186 basis points in yield (-1.86% in yield) in the 10yr US Treasury. In the last five recessions that we have Fed Funds target data for, the Fed has cut rates an average of 625 basis points (-6.25%) and a minimum of 500 basis points (-5%).

With the Fed at 1.125% now, it is easy to imagine a negative Fed Funds Rate and negative Treasury yields in the next recession. A recent Bloomberg article points to new research from Harvard professor Kenneth Rogoff suggesting that negative interest rates have been proven to work and are a viable choice for the Federal Reserve.

In the next recession we expect rates to fall nearer to Japan and Germany type levels; below 1% and possibly below 0.50% or 0%. Using short-hand, estimates of performance can be calculated using assumptions for where the 10yr UST falls to.

click image for large legible version

*This is a short-hand estimate of what returns may look like before any fees or commissions. This simple model does not take into account carry, rolldown, or active management. Returns could easily be higher or lower than these estimates at these terminal yields. Higher yields would most likely result in lossses.

Confusion In Bond World, As Eurodollar Shorts Hit New Record High Over $3 Trillion

One week after we observed the biggest monthly short squeeze in 10Y TSYs in history, it was a relatively calm week in the longer-end of the Treasury curve.

According to the latest CFTC data, spec net shorts in aggregate Treasury futures was little changed from the previous week at 612K contracts in TY equivalents. While, they continued to pare net shorts in TU and TY by 18K and 14K contracts, respectively, they increased their  net shorts in FV and TN by 35K contracts and 6K contracts, respectively. Spec net shorts as share of open interest was unchanged at -5.8% over the week and was at about -2.0 standard deviations away from neutral.

While net Treasury futures shorts are now back to the lowest levels since early December 2016, traders continued to pile into the short-end betting massively on further rate hikes as Eurodollar shorts push on beyond $3 trillion: in the last week specs sold another 73K contracts in Eurodollar futures, taking their net shorts to the seventh successive week of record high of -3,129K contracts.

What is surprising is that there was no short covering after Bill Dudley"s March 31 comments which were taken as dovish by the market, sparking EDs to flatten and reds to outperform on potential for a less hawkish Fed in 2018, which as we observed last week prompted a collapse in the Eurodollar 2018 spread (EDZ7/EDZ8) to briefly slide below a key support level on what was seen as the last sign of "reflation trade" capitulation on the front end.

 

While the mid-week CFTC report captured the market reaction to the initial round of Dudley comments, it failed to take into account Dudley"s Friday "little pause" discussion, which as we quoted RBC on Friday afternoon, prompted "Devastating Eurodollar Unwinds."

The confusion following the contradictory Dudley statements prompted Morgan Stanley to announce on Friday that it was taking off its EDZ7/Z8 flattener, but keeping a EDZ7/Z9 flattener. This is what Morgan Stanley"s Matthew Hornbach said over the weekend:

Did Dudley change our mind?

No sooner had we published our thoughts on how markets price the pace of rate hikes than Dudley clarified his remarks from last week.

Some people misconstrued what I said last week. I said a little pause. A pause is pretty short already, and I think a little pause is even shorter than that. Presumably at the time that you make the decision on the balance sheet you might want to forgo the decision on short-term rates just to make sure that the balance-sheet decision doesn’t turn out to be a bigger decision than you thought you were making. So, I would emphasize the words ’little pause".

We said last week that we thought Dudley"s original comments suggested that, upon the initiation of balance sheet reduction, if financial conditions tighten too much, the Fed may have to take a step back from raising the fed funds target rate. We never thought he meant going on hold for an extended period of time. So now that Dudley has clarified his view, we no longer suggest investors hold EDZ7/EDZ8 flatteners.

However, we still suggest investors enter EDZ7/EDZ9 flatteners based on our analysis of how markets priced the pace of rate hikes in previous cycles. We looked at 3 historical hiking cycles and here"s what we found:

• The Fed delivered more rate hikes than the market expected early on in these cycles, but delivered fewer than the market expected toward the end.


• The Fed delivered fewer hikes than expected toward the end of these cycles because it cut rates during the period in which the market had previously expected hikes to occur.


• The market never fully priced the pace at which the Fed ended up delivering hikes from each cycle"s start to its end.


• At their most hawkish, markets priced 2/3rds of the annualized pace of the previous 3 hiking cycles, on average.

At present, the market only prices 2 of the 3 hikes the Fed projects over the next 12 months. Our analysis of previous cycles suggests this pricing is fair, even if the Fed delivers 3 hikes as projected. 

Hence, we don"t see the need for EDZ7/EDZ8 to flatten from current levels.

However, the potential for the prospect of balance sheet reduction in 2018 to tighten financial conditions enough to warrant a pause in rate hikes, even if not strategic, and possibly rate cuts eventually, means that the market is not likely to price more than 3 rate hikes on net through 2019, in our view. Hence, we still suggest investors embrace EDZ7/EDZ9 flatteners

With Eurodollar shorts failing to be squeezed into last week"s violent move, we anticipate that Dudley"s clarification will only add to the net shorting on the short end. Of course, just like with the record 10Y short squeeze, it is a matter of when not if, the trade will unwind. As such we continue to look for the dovish catalyst that may lead to epic carnage among the Eurodollar trader community once this trade begins to move in reverse first gradually, and then quite rapidly.

The Scariest Forecast For Treasury Bulls

With Trump"s border tax adjustment looking increasingly likely, the stock market - as JPM has warned in recent days - is starting to fade the relentless Trumponomic, hope-driven rally since election day instead focusing on the details inside the president-elect"s proposed plans. And, as explained earlier in the week, if the border tax proposal is implemented, economists at Deutsche Bank estimate the tax could send inflation far above the Federal Reserve"s 2% target and drive a 15% surge in the dollar.

While this would be bad for stocks, as a 5% increase in the dollar translates into about a 3% negative earnings revision for the S&P 500 all else equal, a surge in inflation would also wreak havoc on bond prices, and send interest rates surging, at least initially, before they subsquently plunge as a result of a rapidly tightening, deep "behind the curve" Fed unleashes a curve inversion and recessionary stagflation becomes the bogeyman du jour.

There"s more.

In a separate report by Deutsche, the bank looks at future prospects for rates and concludes that "tightening monetary policy, higher breakevens, and declining central bank purchases relative to net supply should all contribute to significant bearish steepening during 2017."

In its analysis of future bond rates, Deutsche Bank says that the biggest risk is that when looking at the menu of "threats" presented by the Trump stimulus, "there is a significant risk that if the Fed decides to aggressively lean against higher inflation expectations, the entire “regime shift” might stall. That is, higher wages and inflation expectations are a prerequisite to the substitution of capital for labor, which is in itself necessary for more rapid productivity growth and hence higher potential growth and sustainably higher levels of r*."

And then the focus shifts so that whatever degree of accommodation is warranted, there will be the push to rebalance away from rising short rates to shrinking the Fed’s balance sheet, in other words, the Fed begins real normalization.

In DB"s model, the net effect of ending reinvestment of SOMA portfolio run-off, some asset sales, and an ECB taper is almost 200 bps. This would allows 10s to move well over 4 percent in 2018. That although roll offs are significant - maybe $50 billion/month – in order to get the balance sheet down from more than $4 trillion to say $1 trillion before the 4-year presidential term is over would still require asset sales of  approximately $50 billion.

Assuming Deutsche Bank is correct, the result would be the scariest forecast bond bulls have seen in years: a 10-Year TSY whose yield fades all gains attained during the past decade, in the span of just two short years, hitting 4.5% in early 2019. The adverse implications from such a fast, steep move on all asset classes, not just bonds, would be devastating.

Will this forecast come true? Readers can make their own determinations upon reading DB"s assumptions:

Formally, DB"s model of 10s has three explanatory variables. The main driver is the ratio global QE purchases to net supply in nominal terms with a nine-month lead, i.e., the market is forward looking. Global QE and supply figures are from the US, Europe and Japan. The other two variables in the model are Fed funds and the 2s/funds spread. The model is estimated between October 2006 and September 2016.

These assumptions are summarized in the following three scenarios:

1. Base case: Trump’s fiscal stimulus, amounting to about $530 billion per year for ten years.


2. Base case + ECB taper + Fed portfolio rolloff. In this case, 10s are about +70bp higher in yields than in the base case.


3. Base case + ECB taper + Fed portfolio rolloff + Fed asset sales. 10s are about +100bp higher in yields than in base case.

The assumptions in the scenarios are:

• President-elect Trump’s stimulus package, scored by the Committee for a Responsible Federal Budget adds $5.3 trillion to the deficit over the next decade. This averages to $530 billion per year, starting in July 2017, around the time the plan is expected to be passed by Congress.


• The ECB tapers QE purchases by ½ in 2018, and stops all purchases in 2019.


• Fed balance sheet reductions: The Fed stops reinvestments of maturing Treasuries and MBS pre-payments starting Q4 2017. Asset sales at $250 billion in 2018 and $500 billion in 2019.


• The Fed funds target range rises to 2.50%-2.75% by year end 2019, with the 2s/funds spread at 60bp.

Visually:

Needless to say, DB is convinced that there is a lot of pain coming for the bond market. To wit:

"Our strongest market view, therefore, is that investors should be short duration. Rates are going higher. The curve should end up steeper but this Fed"s initial reaction as per this week can confuse curve dynamics. Real rates should not rise more than breakevens. In the short run dollar strength should persist."

We are far less confident, especially if indeed the border tax is implemented, sending the dollar soaring, US exports, and GDP crashing, and corporate profits plunge. In short: if Trump unleashes a recession by implementing a policy which is meant to eliminate the US trade deficit.

In such a case, forget steepeners: buy every flattener you can get your hands on, and then use leverage, because before you know it the 2s30s will be back in the double digits, then single, and then, not too long from now, negative.

Whether that is the catalyst that will kick off QE4 or whatever the current number is, we don"t know, but by that point China will be spitting up blood as a result of a historic collapse in the Yuan, hundreds of billions in monthly outflows and a paralyzed, and crushed financial system. Ironically, in light of the devastation that may soon befall China should Trump"s policies pan out, the US - recession or not - may still be the "cleanest dirty shirt" in a world where things are about to get very messy.