Macro
Equity and bond prices took a hit on Tuesday, after reporting hot JOLTS data (Job Openings and Labor Turnover Survey). Available positions rose to 9.6m from under 8.9m (revised) in July, with little change to hirings (5.9m) and quit rate (2.3%). The good news “ongoing strength in the US labor market” was interpreted as bad news for equities, because it increased odds that the FED will hike again. Some analysts are questioning quality of JOLT Survey as the number has been volatile and the response rate (from roughly 21,000 business and government establishments) has been falling for many years and its now under 31% (compare to over 60% decade ago).
Till now consumer and labor market remain robust and the FED had a trouble cooling demand to reduce inflation. the declines in the inflation where largely driven by the improvements on the supply side. Additionally, due to upcoming elections it will become harder to implement signifcant adjustments to the monetary policy, without a perception of such move being politically motivated.
Rates
We are currently in the regime shift from the 15 years of ultra easy monetary policy to a more restrictive period. Pendulum swings both ways and the market move tend to overshoot, during a period of paradigm shift. That’s because there are significant changes that need to be priced in, and investors tend to adjust slowly, before they adjust fast and overcorrect. This is why the long-term rates may have more room to raise.
Many funds position for this overshoot, which is reflected in the large short position in the US Treasuries. Currently futures on 2Y and 10Y yields have the largest net-short position in over 20 years. In addition to the momentum we see in yields and their tendency to overshoot mentioned in the first paragraph, there are few major motives behind this trade:
- Supply imbalance. Waive of supply from the Treasury as the FED is reducing the size of it’s balance sheet. At the same time we have decrease of international demand on US treasuries. This makes asorbing of this duration supply much harder and gives upward pressure to the long term yields.
- Possitive carry. When shorting long end, investors make positive carry, thus they are earning positive interst differential as long as the yield curve remains inverted.
- Historical tendency. Typically 10Y raises and matches the terminal FED funds rate in the tightening cycle, which with currently still inverted curve, gives rates more room to increase.
Profitability of shorting 10Y treasuries has been reduced by rising borrowing costs in the repo market, as well as increased convexity. Also the gap between 2Y and 10Y is now almost fully close, which increases the risk/reward ratio.
On the other hand, many investors are finding the current long term rates of nearly 5% on 10Y and 30Y attractive. They argue that the equilibirum rates under new regime should not be more than twice of what is twas in the old regime of easy monetary policy. This mentality caused many fixed income investors to be ‘early long, and wrong’.
What lead investors to lock in longer rates early is the FED’s sharply investred dot plots. Plot reflected that the FED will raise rates to fight inflation over a hort period of time, but then start cuttig them as soon as 2024. This believe is what caused the long-term rates to remain suppressed and the yeild curve to remain inverted for so long.
Credit
There is a modest pickup in default rate of higher leveraged, lower rated issuers. US credit spreads levels appear suppressed, as market is in disagreement on where we are in the business cycle. From one hand those tight spreads do not offer a sufficient reward for default risks, on the other hand the total return is historically high due to high nominal rates.
Surge in yields causing a slow down in issuance, and weekly volume end up way below estimates. Corporations who are trying to ‘wait out’ high rates are under pressure as spreads started to move higher. Over last 3 weeks when accounting for 10Y rates increases and widening spreads, we had 80 bps increase in the HY financing costs.
Over last decade many companies adjusted their capital strucuture, and increased gearing to take advanatage of the cheap cost of capital. Most of those comapnies got cought off guard by the rate increases, and where not able to adjust their capital structure on time. They soo will be force to refinance their debt at a much higher rates.