As we discussed in part one of our Q1-2 2023 Economic Outlook, the financial sector appears well-positioned for an economic downturn. That being said, we are seeing the deterioration in delinquencies ...
Capital Markets
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4 min read
A funny thing happened on the way to the great reflation trade that, just a few weeks ago, was the dominant market theme. The reflation trade was supposed to get out in front of strong inflationary pressures as well as the sooner-than-expected withdrawal of some of the Fed’s extraordinary monetary policy support. The yield curve was supposed to steepen, with long-term rates like the 10-year Treasury note going through two percent for the first time since early 2019. Instead, what we have gotten over the second half of June and all of July has been a head-scratching, curve-flattening rally in the long end of the yield curve. What the heck happened?
Many market pundits have blamed a worsening global and domestic COVID outlook as the new Delta variant wreaks havoc, worsening the outlook on inflation and economic growth. From a macro perspective, this makes some sense, however, it is a little hard to believe that sentiment could have changed so quickly and decisively. After all, risk markets such as stocks and high-yield bonds barely flinched on bad COVID news and instead continued to rally almost unabated. We realize, many times, the Treasury market gets the bad news ahead of stocks, but we do not think this is one of those instances. Many times, head-scratching bond market rallies (or sell-offs) have a lot more to do with trading flows as opposed to market outlooks. Think of it like the micro look as opposed to macro. Often, the trade flows from different sectors of the market affect one another like a string of dominos. We think that is what has happened in the Treasury market.
It is hard to say what exactly stopped the 10-year Treasury’s yield from ascending toward two percent at the end of May. We can see that the U.S. Dollar, as measured by the ICE U.S. Dollar Index (DXY), appreciated nearly 3% from the end of May to the end of June. There has definitely been capital flight to the U.S. Dollar as our vaccine program has significantly outpaced all of our trading partners. Some of this capital goes to the safety of U.S. Treasuries. Additionally, data has been showing that foreign central banks have continued to step up their purchases of U.S. securities. Finally, for global money managers, Treasury yields, adjusted for currency hedging, have become attractive to Japanese, German, and British government debt. There is a good sense these large entities stepped up their buying of Treasuries as well. This was probably enough to throw a monkey-wrench into the rate sell-off that most of the market predicted.
What we think followed next was the phenomenon of Fear of Missing Out, or FOMO, from the banking sector. While banks, especially large banks with trading and underwriting operations, had a blowout year in 2020 and a great first quarter of 2021, CEOs highlighted weak loan demand and record-high amounts of retail deposit inflows. For example, if we look at the 2020 Annual Report for Bank of America, we can see that loans increased only 2.5% year-over-year, while deposits at the bank soared 18.3%. For perspective, in 2019 (a year where the economy began to slow), loan books grew 3.4% while deposits grew by 4.9%. While Bank of America is one of the nation’s largest banks, this phenomenon occurred across the entire banking and credit union industry in 2020 and early 2021. When banks have an imbalance of too many new liabilities with not enough new loans, they buy debt securities for their investment portfolio. Generally, they buy Treasury and Agency Mortgage-Backed Securities. Sticking with Bank of America, the bank’s holding of debt securities more than doubled from $216 billion in 2019 to $438 billion in 2020. That is a heck of an increase.
While it is always true that a good portion of the investment portfolios are short-dated, there is still a sizable amount of longer-duration bonds. Additionally, since banks do not have to hold capital against Treasury debt, the risk-weighted return can be relatively attractive, especially if the yield curve is steep or steepening. Therefore, with loan demand still relatively tepid and the market consensus that the yield curve would steepen and longer-term Treasuries yields would rise, we believe that many banks were holding off purchases of Treasuries waiting for higher yields in the late winter early spring. When the rise in yields stalled, banks and credit unions began to chase yields and set up the rally we are seeing now. Once yields started heading down sharply, we are sure there were “bad speculative shorts” that needed to be closed out through buying back Treasuries and Treasury futures. Additionally, as rates fell sharply, the mortgage servicer industry needed to buy duration to hedge their master servicing rights portfolio, which leads us to a sub-1.30% 10-year yield!
So where do we go from here? Last Thursday, the Wall Street Journal ran an article “Borrowing is Back as Sign-Ups for Auto Loans, Credit Cards Hit Records,”
Americans are borrowing again, in some cases at levels not seen in more than a decade. Consumer demand for auto loans and leases, general-purpose credit cards, and personal loans was up 39% in April compared with the same period last year, according to credit-reporting firm Equifax. It was also up 11% compared with April 2019, according to Equifax, which measured how often lenders checked consumers’ credit reports to make loan decisions.
Granted, we are talking about year-over-year increases off rock bottom levels of April 2020 but, still, loan demand is beginning to go higher. With that said, if we anticipate the flows, we could see bank portfolios demand much fewer Treasuries in the second half of 2021. If we combine that with the ever-increasing supply of new Treasury debt and a receding Federal Reserve, yields could be going up—maybe by a lot and maybe soon.
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