The bond market says “Yeah”

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Welcome back. This week is coming to an end, and I promise that we won’t talk about inflation at all next week. I’m serious this time. But today we will.

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Why high inflation is ignored

Consumer Price Index Come in Slightly higher than expected on Thursday, the core inflation rate was 3.8%, but government bond yields remained unchanged. This is a bit strange in principle. Inflation is bad for bond prices, so it should push up yields. But the indifference of bonds is not surprising. Bond yields peaked in March. Since then, the story has always been “Look at the 10-year Treasury bond, it says inflation will be temporary and everything is cool”, or “Look at the 10-year Treasury bond, it says investors think inflation will be temporary , But the boy is that they buy canned food and guns for a surprise.”

I am closer to the former than the latter. Once again, most of the factors that drove the index up in May were things destroyed by the pandemic, including hotel rooms, or things that caused bottlenecks, such as cars. Capital Investment Macros has a neat chart of popular categories:

All of these should be temporary. But we cannot relax completely. Three comments on why not.

First, not all categories that are heating up can be excluded as a natural result of reopening. An example is the annual growth rate of housing costs (“owner’s equivalent rent”) of more than 4%. This is not a crazy number (“so far normalization, not a surge,” Strategas wrote in a reassuring report). But it makes me want to see what the numbers look like next month.

Second, there is a large amount of price-insensitive demand for US sovereign bonds, which may prevent yields from responding to inflation concerns. They are the most liquid assets and are used for various purposes other than maximizing returns. They are a safe alternative to cash and a collateral that can be used almost everywhere.

one example.My former colleague Tracy Alloway is now at Bloomberg good article Regarding the increase in demand from banks for US Treasury bonds this week, banks need to hold a large amount of highly liquid security notes. The collapse in yields on other options has shifted bank demand to U.S. Treasury bonds, which have purchased hundreds of billions of dollars in the past year or so.

Most importantly, please remember that the yields on US Treasury bonds are still much higher than other sovereign bonds. Japanese bond yields are basically zero. Germany’s rate of return is negative. Therefore, if you have a security sovereign bond configuration that needs to be populated, what do you intend to populate it with?

And, oh yes, on it that, The Federal Reserve buys US$80 billion of US Treasury bonds every month.This is almost half of the net issuance in the past 12 months data From the Securities Industry and Financial Market Association, it accounts for about 4% of the outstanding shares of US Treasury bonds.As a trader who tweeted Five minute macro in conclusion:

“The Fed goes deep into the bond market on each maturity date, but people still want to analyze the impact of each swing and swing in the bond market on the economy or investor expectations. The old habit is hard to die, and the other option is quite empty.”

I mean, if the 10-year U.S. Treasury bond yield can’t tell us much, how can I make a living? but no matter. ..

Finally, we have a very simple explanation of what is happening, that is, the impact of inflation concerns on yields is overshadowed by the fall in real interest rates. The following is a five-year market-derived inflation expectation starting five years from now, compared with the 10-year yield (Federal Reserve data):

In short, inflation expectations can rise while yields remain the same because investors’ demand for currency inflation-adjusted returns, that is, real interest rates, is falling.

I wrote about the real interest rate yesterday. Thinking about it since then, it suddenly occurred to me that a very low and declining real interest rate is difficult to distinguish from investor nihilism (“All returns are terrible, I will accept anything that has a little profit , To cash in and wait for something to happen will make me fired, is this time to drink?”) But this is another hour’s question.

Banks and cryptocurrencies

Basel Committee on Banking Supervision think Banks holding cryptocurrencies should maintain capital equal to the full value of these digital assets.In the words of Basel: “Capital [should be] It is sufficient to absorb all the write-offs of crypto asset exposures without causing losses to bank depositors and other senior creditors. ”

This makes perfect sense and makes cryptocurrency a terrible business for banks.

This makes sense, because cryptocurrencies (except for those permanently tied to more stable assets, which Basel has excluded from heavy capital needs) fluctuate greatly. Bitcoin depreciated by nearly half in a few weeks in May for no reason. Banks cannot bypass the influence on things that have such behavior.

This is obvious and supplements the technical or criminal risks associated with encryption (“key theft, disclosure of login credentials, and distributed denial of service attacks”).

But banks basically rely on leverage to make money. Their return on assets is about 1% to 2%, and they leveraged it by about 10 times, resulting in a return on equity that is only slightly higher than their cost of capital. They seem to have made a lot of money in good times, but that is an accounting illusion. Throughout the cycle, this is a very difficult business. Unavailable assets do not meet the business plan, at least not on any important scale.

This is usually not a criticism of Bitcoin or crypto assets. It shouldn’t bother cryptocurrency believers too much. A key part of encryption is that it will allow users to tell the government-controlled banks and currency systems to be buzzing. If the system also wants cryptocurrencies to buzz, everyone should be happy. Bitcoin did not have much influence on the committee’s news.

However, the Financial Times did find that a banker was willing to say that the committee was wrong in the background:

“We have all seen what happens when you drive activities from a well-regulated system to the Wild West…. Do the regulators want adults to do business or teenagers to do business?”

This is a very bad argument (“If you don’t let the banker smoke, who will smoke all the cigarettes? Kids!”). Yes, we do want to handle encryption in some kind of independent system. If it explodes, we don’t need to hold a mortgage bond sale to fill the hole left by the explosion. The interesting question is how to supervise and tax this independent system.

A good book

Martin Sandbu of the Financial Times think There is no labor shortage, no general wage pressures, and no sticky inflation. He used a lot of data and reasonable logic to support his argument. If you feel panic, please read his column.

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