What's Going On?!

Woah.

I thought yields were meant to be at like 3% by now?!

I thought we were meant to be praising the bond vigilantes for being right?

I thought that we were meant to see a treasury yield curve steeper than Everest?!

Clearly not.

I'm going to outline why I think we are in this current regime (nothing has changed, by the way) and where we're headed next, since I think it's pretty important to highlight for future reference.

Where have we come from?

Let's go back to the start of the year.

I'd sent you these two articles, outlining my view on inflation and why the inflationista narrative was likely going to fail within a market based context.

The belief driving the sentiments earlier in the year is that we would not see some kind of massive push higher in yields - we simply couldn't, since the long term trend in the US 10 year was lower!

Chart here for ya.

You cannot debate with long term trend direction.

Right now though, I reckon (and I did mention this a few weeks ago), that the bond market's key driver is not inflation right now, but is to do with other factors.

Check out these two charts now.

Above we have the 10 year breakeven inflation rate (white), the 10 year yield (orange) and oil (blue, or cyan, as I would be forced to call it by my girlfriend).

What do we notice?

Well, although oil has climbed higher, breakeven inflation (market based inflation expectations measure) peaked in mid-May, and the US 10 year yield in late March.

This, in my view, certainly shows a decoupling of inflation being the key driver behind bond market moves.

So what could be the driver then?

Let's look at China shall we?

Impulsive credit

There have been big stories coming out of China in the last two weeks, mostly connected with large corporations.

Tencent backed DouYu x Huya's merger was blocked, Ant Group had restrictions placed on them for monopolistic containment (remember their listing was banned in November because the People's Bank of China thought they were underwriting sub-prime loans, an important factor that we'll come onto) and DiDi, the Chinese ride hailing app, was fined for collecting users' data illegally.

This is all a broader policy move to crack down on leverage in the economy and to stop Chinese tech giants from becoming a threat to government in our view.

And this is noted also by ING...

By 'helping out' SMEs exclusively, they are showing that there is both a political and economic motive at work here; but clearly, the CCP and PBoC don't particularly like Chinese tech's might at the moment!

We had mentioned this policy of deleveraging a few times previously, specifically in the below piece (and the property market piece contained within) 👇

So back to the key point...

What does the subtitle have to do with this?

Well, a picture tells a thousand words...

See, we reckon that issues out of China are in fact driving the demand for US Treasuries at the moment - go back to the chart with oil, breakeven inflation and the US 10 year yield.

Whilst the market is focused on inflation, this is the real driver for us!

And the guys at Quant Insight confirmed this in their model on long term factors influencing the price of the US 10y Treasury...

Highlighting China's 5y CDS (credit default swap - it can show the likelihood of default) in this context is important, especially considering that a lot of global growth has stemmed from Chinese credit creation and heavy expansion.

And here is the Chinese 5y CDS...

No, it's not particularly high, but it is enough to look at the rate of change and potential for it to continue higher based on the current policy stance of stomping out leverage in the Chinese economy.

What is rather interesting is that looking at the shorter term influences on the US 10 year Treasury, we note that Chinese GDP is a key factor in the direction of the bond.

This is essentially saying that if Chinese GDP is flattening, then the US 10 year in the short term, should increase in price, leading to a lower yield - and in the short term, this has replaced Brent as the key negative driver (which we can use as a proxy for inflation expectations).

And judging from the Chinese credit impulse, we can say that there are likely going to be expectations for much softer Chinese growth.

We can see that Chinese growth rates are projected to be at a much lower average than in previous decades...

And I have a funny feeling that there might actually be misses here...

Drivers matter, but what to look at?

Something I'm taking a bit of a look at is the spread between the SP500 dividend yield and the US 10 year yield.

It's currently at around 8bps.

Something to watch going forward is how 'sticky' both data points will be.

I.e, if the SP500 dividend yield stays flat, but the US10 year yield continues to decline, then stocks become more attractive again.

If, however, the dividend yield starts to tank further with the US 10 year Treasury yield remaining flat, then I would say that we should seriously contemplate issues going forward.

See, that would imply the curve is starting to invert.

What do I mean by this?

Note the chart below.

Back in 2019, we started to see the curve invert EVER so slightly in the September, and we can show that by looking at the 2s10s differentials.

See, the 2 year yield was earning more than the 10 year yield for a very brief period of time.

Then we had the pandemic 6 months later when the shit hit the fan.

But something to note is naturally how the 2y yield behaved post pandemic.

It's gone no where, since the Fed has no plans to hike at all.

And from my perspective...

I think a hike will be delayed way more than the market thinks.

From this perspective, then, we might see a big, big catch up with the 10 year moving considerably lower, especially if we consider the policies that China has undertaken over the last few months.

It could be that geopolitics tensions really accelerate and a broader flight to safe, quality assets occur, in which case the 10 year yield will likely move closer to parity with the front end of the curve.

And if global growth does fail to decelerate, what happens to the earnings of US firms? 👀

Many 'ifs' though but I think this is a dynamic we should pay attention to moving forward.