Dr. Ed's Predicting the Markets #article

Dr. Ed's Predicting the Markets #article

The 10-year US Treasury bond yield has been trading in a tight range between 0.52 percent and 0.88 percent since March 23, when the Fed implemented QE4ever (Fig. 1). The average yield since then through Friday’s close was 0.68 percent . The Fed lowered the federal funds rate by 100bps to zero on March 15 (Fig. 2). However, so far, Fed officials haven’t announced that they intend to peg the bond yield below 1.00 percent . But that seems to be what they are doing. If they weren’t doing so, the bond yield would probably exceed 1.00 percent based on its past relationship with various economic indicators. Consider the following:

(1) Price ratio for copper / gold. A fairly good predictor of where the bond yield should be (Fig . 3) was the ratio of the nearby copper to gold futures prices multiplied by 10. For a short while, when the yield traded below (above) this ratio, it usually moved higher (lower). The bond yield was 0.76% on Friday, while the yield implied by the ratio was 1.61%. Since 2004, the spread between the two has varied between -128bps and 188bps (Fig . 4). It's at -85bps now.

Dr. Ed is one of the 2019 Top Voices in Economy & Finance on LinkedIn. Institutional investors may sign up at https:/lnkd.in/eYNwch8 for a complimentary trial of his research service. He is on Amazon with his book, "Predicting the Markets." At https:/lnkd.in/eAh3urh, his latest book, "Fed Watching for Fun & Benefit," is also available there.

(2) Economic surprise. The 13-week change in the bond yield has been highly correlated with the Citigroup Economic Surprise Index (CESI) (Fig. 5). This year, the CESI has soared from a record low of -144.6 on April 30 to a record high of 270.8 on July 16. The index was down to 134.2 on Friday, remaining well above all its previous cyclical peaks prior to this year. Yet the 13-week change in the bond yield was just 12bps on Friday. (By the way, the CESI has had a seasonal tendency to rise during the second half of most years since 2009—a pattern that also has been reflected in the 13-week change in the bond yield but not so far this year.)

(3) Purchasing managers index. Since 2010, there has been a fairly good correlation between the M-PMI and the bond yield (Fig. 6). It continued to hold earlier this year when both dropped sharply together during the two-month lockdown recession in March and April. The M-PMI has rebounded from 41.5 during April to 55.4 during September, while the bond yield remains under 1.00 percent .

(4) Yield on TIPS. The Fed's QE4ever should have raised questions about the potential inflationary impact of such an open-ended ultra-easy monetary policy on the bond market. But assuming that the Fed holds a cap on the bond rate, as I do, investors have bought up Treasury Inflation-Protected Securities (TIPS) for inflation security because they can't get that in nominal returns. As a result, the 10-year TIPS yield plummeted from -0.04% on March 23 to -0.95% on Friday (Fig . 7). The yield gap between the bond yield and the TIPS, which is a frequently used proxy for projected inflation over the next 10 years, jumped from 0.50 percent on March 19 this year's low to 1.71 percent on Friday (Fig. 8)

By the way, the 10-year TIPS yield is very closely correlated with the real bond yield, defined as the 10-year nominal yield less the yearly percentage change in the PCED (personal consumption expenditures deflator) inflation rate (Fig. 9). The correlation between the inflation proxy and the PCED inflation rate isn’t as high (Fig. 10).

Interestingly, the inflation proxy is much more highly correlated with the nearby futures price of copper and with the inverse of the trade-weighted dollar (Fig. 11 and Fig. 12).

5) Fed buying bonds. From February through September, the Treasury issued $259 billion in publicly held marketable bonds, with the outstanding amount rising to a record $2.67 trillion (Fig. 13). Over the same period, the Fed purchased $338 billion in Treasury bonds, holding 37 percent of the outstanding supply.

(6) Yield-curve targeting. At his June 10 press conference, Fed Chair Jerome Powell was asked by Nick Timiraos of the WSJ about the possibility of “yield caps.” Powell revealed that at the latest meeting of the Federal Open Market Committee (FOMC), the participants received a briefing on the historical experience with yield-curve targeting (YCT) and said that they would evaluate it in upcoming meetings.

According to the Minutes of the June 9-10 FOMC meeting, the Fed’s staff presented a two-handed assessment of YCT. On the one hand, they said that it could be achieved without the Fed having to buy lots of bonds. On the other hand, it might require the Fed “to purchase very sizable amounts of government debt.” It seems to us that by not formally announcing a target for the bond yield, the Fed has had to purchase lots of bonds to keep it under 1.00 percent .

The staff also warned that under YCT, “monetary policy goals might come in conflict with public debt management goals, which could pose risks to the independence of the central bank.” You think? It seems to me that by lobbying so publicly and frequently for more fiscal stimulus in recent weeks, the Fed has already ceded its independence in the interest of implementing Modern Monetary Theory in response to the Great Virus Crisis.


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