Financial markets go down the rabbit hole

Just when you thought the financial markets couldn’t get any funnier – they have. On Tuesday, US Federal Reserve Chairman Jay Powell indicated that the Fed may raise rates more than expected to combat inflation.

For the first time since 2007, the two-year Treasury yield has increased by more than 5 percent. But the 10-year yield has barely moved up. This has caused the yield curve to be in what is known as an “inversion” of Alice-in-Wonderland state, in which it costs more to borrow short-term money than long-term. By Wednesday, the spread had widened to negative 107 basis points — an extreme pattern seen only once before, in 1980 — when Paul Volcker, then Fed chair, was unleashing shock therapy.

What sparked this pattern? One explanation is that bond investors think Powell will follow in Volcker’s footsteps and bring about a deeper recession. After all, historical models suggest that “every recession since the mid-1950s was preceded by an inversion of the yield curve”, as economists at the San Francisco Fed recently noted. He noted that “there was only one yield curve inversion in the mid-1960s, which was not followed by a recession within two years”.

Or as Anu Gaggar, analyst at the US advisory firm Commonwealth, observed last year: “There have been 28 instances since 1900 where the yield curve has inverted; In 22 of these episodes, recession has followed.

But there is precious little evidence so far. Yes, there are signs of rising consumer stress. But as Powell noted this week, the labor market is red hot, and when I met with business leaders in Washington last week, the mood was upbeat.

So is something happening that could cause the reversal pattern to lose its signaling power? We won’t know for several months. But there are two key factors that investors (and the Fed) need to pay attention to: speculative positions and generational cognitive biases.

The first issue revolves around some important figures from the Commodity Futures Trading Commission. Typically, the CFTC reveals each week whether speculative investors, such as hedge funds, are “long” or “short” interest rate futures (i.e. whether they are collectively betting that rates will fall or rise, respectively).

But in a terrible, and ill-timed, twist, the CFTC has failed to release this data in a timely manner due to a recent cyber hack. However, we do know that in early February hedge funds held a record high of “short” two-year Treasuries, ie a big bet that rates would rise.

Without CFTC data, we don’t know what has happened since then. However, regulators told me they now think there is significant holding by funds in Treasuries, a pattern echoed in early 2020. If so, this could fuel a reversal pattern (and cause it to reverse if conditions worsen in the future).

The second issue — that of generational cognitive bias — revolves around investors’ perception of what is “normal.” One interpretation of the reversal pattern is that investors expect the financial ecosystem to return to pre-Covid patterns of ultra-low rates after Powell curbs the Covid-related wave of inflation.

Some economists think it’s a fair bet. For example, this week at the Peterson Institute there was a fascinating debate between economic luminaries Olivier Blanchard and Larry Summers. In it, Blanchard argued that we would soon return to a world where “neutral” interest rates (or a level that does not cause inflation or recession) were very low – which means that the current reversal pattern makes perfect sense. .

However, others believe that it is wrong to think that we will return to the pre-Covid world with low long-term rates as there are major structural changes in the global economy. “Some of the things that make the neutral rate higher may be temporary, but there’s no reason to think it’s all temporary,” Summers argued.

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