August 27, 2020
The ~$3T Cares Act was largely financed by the issuance of T-bills, which means the amount of debt maturing within a year is larger than the Treasury’s stated objectives. In fact, the Treasury’s August refunding announcement indicated that duration supply of 10-year bond equivalence is expected to be ~45% higher in the remaining 5 months of year than it was in the preceding 7 months. At the current QE pace of ~$80B/month, the Fed will only capture ~25% of the increased duration supply over those 7 months. To be clear, past auctions have shown no signs of waning demand, but with short-term rates anchored by the Fed’s commitment to inflation targeting and the Treasury extending the average duration of outstanding debt, the result should be slightly higher yields and curve steepening.
Cyclical: Bond yields reflect market expectations of future inflation. A steeper yield curve means inflation/prices will be higher in the future, which is good thing if it’s based on improved demand/output. Inflation based solely on supply constraints isn’t usually a good thing. The 1973 Arab Oil Embargo resulted in a supply shock and stagnant economic output, which resulted in the coining of the term ‘stagflation.’ Forgetting the explanation from the prior paragraph, it’s also possible to get slightly higher yields and curve steepening from an uptick in inflation, based on a short-term supply/demand goods imbalance. The current supply issues were mostly created by pandemic-related lockdowns and any uptick in inflation expectations is likely to be temporary. But equity sector performance could follow the shape of the yield curve regardless of the explanation. We’re all aware that a flat of inverted yield curve (2-10 spread) is a market signal of future recession. Utilities, Staples and Health Care are supposed to be the best performing sectors given a flat or inverted yield curve scenario, while Financials, Materials, Industrials and Energy should be the best performing sectors during periods of increased slope.
Rotation? We don’t think investors will use growth stocks as a funding source for increased positioning in cyclical/value sectors. Still-light broad equity positioning, record cash balances and an unconvinced investor base (some recency bias combined with more than 3 years of head fakes) are the main factors that should keep markets from a more acute rotation.