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V-Shaped Recovery for Rates?

June 1, 2020

Have you ever seen a baby that gets hurt, but there’s a lag between the pain and the actual scream?  They gasp for air as they try to process what just happened?  And then they let out the real scream?  I feel like we’re in that period right now.  The pain has been so sudden, so shocking, that we are gasping for air.  Trying to process what is going on.  But reality hasn’t actually sunk in and the economic screaming hasn’t started yet.  But it’s coming.


Last Week This Morning

  • 10 Year Treasury down slightly to 0.64%
    • German bund at -0.45%
  • 2 Year Treasury anchored around 0.16%
  • LIBOR at 0.18% and settling into it’s range of 0.15% – 0.20%
  • SOFR is 0.06%
  • Q1 revised GDP -5.0% vs -4.8%
  • Another 2.1mm Americans filed for unemployment, bringing the total over 40mm
  • Dallas Fed Manufacturing only came in at -49.2, vs expected -61 and last month’s -73.7
  • NY Fed President Williams said the Fed is considering Yield Curve Control to cap Treasury yields
  • The Atlanta Fed’s GDPNow forecasts a -51% GDP in Q2
  • Chicago PMI hit an 11 year low
  • Fed Funds futures show a dip into negative territory in June 2021
  • Holy cow it’s June


A V-Shaped Recovery for Rates?

Two weeks ago we put out a newsletter about why rates could go negative in the US, but nearly everyone we speak with is far more worried about rates spiking, particularly in 2021 or 2022.  It’s a valid concern.

The Fed is likely on hold for a very long time.  This is good news for floating rate borrowers, who should enjoy 0% for the foreseeable future.  But this also sets the stage for very accommodative conditions.  Furthermore, the Fed will also allow the economy/inflation to run hot before increasing rates.

What about inflation?  Treasury issuance is setting new records each day.  The Fed is on track to buy about $3T in Treasurys by year end 2021…but what happens when they stop?  Or, in the case of the 2013 Taper Tantrum, when they even first mention the game plan for ending purchases?

GDP is very highly correlated with the 10 Year Treasury.  Let’s look at how they both behaved in the last two recessions.

Financial Crisis

During the financial crisis, rates took a nosedive in mid-October.  On 10/14, the T10 was at 4.08%.  By early December, it was 2.05%.  GDP bottomed out at -8.4% in Q4.

As GDP rebounded off the bottom, rates spiked.  The T10 spiked to 4.00% within six months even while GDP was still negative. In fact, GDP didn’t turn positive for nearly a year.

Remember, there is a distinction between “the markets” and “the economy”.  The markets will move ahead of the economy and then wait for the data to catch up.

Source: Bloomberg Finance, LP

The financial crisis may serve as the best corollary because it was so sharp.  It was acute.  It feels very similar to today’s environment.  But what about the 2001 recession?

2001 Recession

Rather than one large V-shape rebound, there were several.  Given the deep economic scarring during this shutdown, this also sounds like a plausible outcome.  But the takeaway is the same – the T10 dropped from 5.50% to 4.17%, and then rebounded quickly to 5.00%+ again.

Source: Bloomberg Finance, LP

The Fed isn’t stupid.  They know all of this.  They know markets will rebound before the economy does, so I expect more and more chatter about Yield Curve Control (click here to read our newsletter on the topic).  “Yield-curve control, which has now been used in a few other countries, is, I think, a tool that could complement, potentially complement, forward guidance and our other policy actions,” NY Fed President Williams said last week.

In fact, a growing consensus for a rebound increases the likelihood the Fed uses YCC to keep the long end down.  There would be this pent up energy just waiting to be released.  The long end becomes coiled, ready to spring.  The Fed doesn’t want that to happen too soon and kill the recovery, so they intervene by capping yields.

Japan found that YCC policies actually resulted in fewer Treasury purchases than a blanket QE program.  This is especially appealing in the current environment when buying just for the sake of buying isn’t really going to boost the economy.  Instead, commit to capping Treasury yields and then only intervene as needed.  YCC would also lead to a steeper yield curve, which keeps the Fed’s bosses banks happy.

Australia officially began YCC as coronavirus hit, focusing on 3 years and less, while India is believed to be pursuing it as well (although not publicly stating as much).

BUT…BUT…BUT…the Fed has suggested that YCC will more likely focus on the front end of the curve rather than the long end.  A few Fed members in the most recent FOMC minutes noted that buying “Treasury securities on a scale necessary to keep Treasury yields at short to medium term maturities capped at specified levels” could make sense.  That means a cap on the 2-5 Year Treasury yields is more likely than the 10 Year Treasury.  If the 10/20/30 year part of the curve is allowed to “float”, that suggests it will have far more room to run higher than the front end of the curve.

Plus, there’s the issue of the asymmetric risk.  Bloomberg’s Econ team puts the low end of the range on the T10 at 0.30%, but the high end is 1.90%.  Now, a 2.00% T10 is a two standard deviation move, but it’s rooted in a sharp economic rebound plus inflation expectations.  Remember the Big Short?  A 2.00% 10T is the sort of thing those guys would have been betting on.

Here’s the really important thing to remember about markets – they are forward looking.  They will move on expectations of a rebound, before the rebound has actually occurred.

Isn’t it possible that news of a vaccine could be the sort of thing that leads to a Taper Tantrum response in long term Treasury yields?


Fixed Rate Borrowers – Hedging Future Rates

Just because borrowers don’t expect to have many deals pricing this year doesn’t mean they don’t have a lot in the coming years.  Combine that with a fear of much higher Treasury yields and we have a lot of borrowers focused on the T10 over the next 24 months.

Here’s what a $50mm, 1.00% strike, 1 year forward, 10 year swaption would have cost over the last few years.

June 2017             $6.0mm
June 2018             $8.6mm
June 2019             $ 5.1mm
Today                  $  800k

If you believe the T10 will be heading higher, swaptions are very inexpensive right now.


Floating Rate Borrowers

Floating rate borrowers wouldn’t really benefit from a swaption, but we have seen a dramatic increase in longer term caps.  If you expect to have floating rate debt over the next decade, a long term cap could make sense even if the next few years aren’t expected to provide any value.

This graph illustrates volatility in the current cap market.  There’s a lot going on, but the bars just represent seven year volatility snapshots in May 2015, May 2016, May 2017, May 2018, May 2019, and May 2020.  The blue bar is this month.  As you can see, volatility is way up.

But the cost is way down, particularly for the At The Money strikes.  Even though the ATM strike has dropped from 1.91% to 0.50%, the cost has dropped by 50%.  This is why we have seen so many 10 year caps recently, especially with more aggressive strikes.

Caps are usually best suited for three years or less, but it’s hard to argue with longer term protection in this environment.


Week Ahead

In addition to the coronavirus headlines, the tensions between US and China will move markets.  Also, the Fed goes quiet ahead of next week’s meeting.


Click to Open: The Pensford Letter PDF