Interest Rate and Derivatives
What's the US Rates price action telling us?
Written by: Varda Pandey
- Published on: January 15, 2024
- , 2:37 pm
Let’s dissect the pricing of rate cuts – price action on any asset would generally have both speculative and end-user/hedging flows. After the large losses incurred by those who refused to hedge against higher rates post the SVB/regional banks blow-ups in March/April 2023 there would be caution this time around.
We can think of long-only investors’ buying duration in an effort to hedge their asset-liability duration mismatches (Pensions/Lifers and Real money who run Liability Driven Investment mandates) as rates slide rapidly. Global Asset managers who pitched long duration to their end investors at the start of 2023 were finally gratified and likely doubled up on their bets to clock positive returns towards the end of the year.
Combine this with CTAs covering their short positions on US rates through most of November 2023 and there’s greater appreciation for how the momentum flows – those that weren’t themselves expressing deep rate cut views but fearing what they might lose fighting it – have driven price action.
Shape of the US rates curve – why isn’t the dis-inversion aggressive yet? – it’s cleaner to assess pricing through swaps (cash bonds have idiosyncratic/lagged flows that are harder to deal with) in the forward space. Curves have been inverted for over two years now, but it’s unlike the inversion that have predicted recessions before with almost remarkable certainty. Furthermore, it’s the disinversion of the curve that signals the looming onset of a recession in a way to brace for lower rates. A 1yr forward 2s10s swap spread has steepened about 20bps since end-Oct 2023, that’s starkly underwhelming when you think about spot rate moves of 115-130bps across the curve. For consensus narratives of imminent rate cuts since Dec FOMC a stronger bull steepening should have followed through but hasn’t – in fact the steepening post the Dec CPI release flips from a bull steepening on the spot curve to twist steepening on forward curves (front end yields coming off while back end steady or higher). Which means some more FOMO flows from those who missed being long the front end but likely holding off on longer duration buying as valuations aren’t attractive for the supply ahead.
TIAA and Stock-Bond correlation – 15 years of QE and zero rates made us familiar with the term TINA (there is no alternative) because keeping your money in cash earned nothing. But after the relentless Fed hikes/end of QE and overnight rates at 5.25-5.50% there is an alternative (TIAA) even in cash. Dollar assets have been the superior carry (and credit) investments through this hiking cycle, in fact even in the credit space US junk spreads have offered (than EM) risk-reward for investors. This brings us to the subject of Stock-Bond correlation that’s crucially tied to the level of interest rates (more importantly real rates) and the accompanying regime. Unanchored expectations in a high inflation backdrop induces higher volatility for both equities and bonds which intuitively implies a statistically significant and higher positive correlation between the two asset classes similar to what we saw in 2022 and a 20% loss for traditional 60-40 portfolios that rely on bond exposure to hedge stock returns and vice versa.
Prolonged inversion of the yield curve – higher front end yields – coupled with lower and more stable inflation expectations (which is what we saw in 2023) meant more attractive short dated real yields, a stronger case of TIAA relative to equities in a potential soft landing backdrop. The massive build-up with US money market ETFs – record USD 1.3 trio in 2023 – closes the loop on the argument. By the way – well over 50% of the S&P 500 companies beat earnings estimates for the September ending quarter in 2023, with an uptick in overall profitability, but equity investors too were only eyeing the rates sell-off.
Term premia and Stock-Bond Correlation – a positive correlation between bonds and equities in the absence of QE (as long as we don’t fear a hard landing) intuitively warrants a higher term premia. Real money/Long-only Cash investors importantly (among others) have these investment considerations – a) real yield on fixed income assets b) prospects for generating alpha/beating benchmark returns c) bond-stock correlation d) volatility-adjusted carry on assets. Large duration buying from cash investors as in November and December 2023 may not remain as strong if the last mile on inflation is stickier than current expectations – Dec CPI wasn’t encouraging. A steeper interest rate curve would still be likely, but with a higher probability of flows rotating from longer duration towards the belly than a strong bull steepening on the forward curves.