Bond Market Volatility Has Been High But End Is In Sight

The Days Ahead:

• Jobs numbers.

This Week:

• Consumer confidence has been shaky recently.
• That’s mostly due to gas prices and should improve.
• We’ve seen high volatility in Treasury prices…even more than for stocks.
• Some of the problems should ease in the next month or so.
• Europe’s export boom but it’s all in the wrong places.
• OPEC+ announced a cut. Markets couldn’t care less.

What’s Up With Consumer Confidence?

Consumer confidence has taken a hit for most of this year, even as the economy, employment and inflation all improved. What’s going on?

Usually measures of consumer confidence are reliable. People answer all sorts of questions on whether business conditions are good, jobs plentiful, if income and salaries are rising or if there’s a likelihood of recession. Normally the confidence levels peak just before a recession, drop and then slowly recover.

Here’s what the two main surveys, from the University of Michigan and Conference Board look like:

In both cases, confidence has ebbed and risen but is mostly unchanged from a year ago. The surveys ask slightly different questions but cover most people’s concerns. Here are the subjects:

The two surveys also ask the questions in slightly different ways. For example, the Conference Board asks people to rate current business conditions as positive, negative or neutral. Or on inflation, it asks if the rate will be higher, the same or lower a year from now. The University of Michigan report is more direct and comes right out with:

I dunno. The second question seems more visceral to me and if I’d just filled up with gas, I might answer based on my very recent experience.

Over time, the questions shouldn’t lead to big discrepancies but as our chart shows, the two are quite far apart right now. Any prior gap, as in 1988, 1999 and 2019, tends to stay stable for a few years and then close. Not this time. The gap is large for the third year in a row.

We think this can be explained by two points.

First, gas prices have been very volatile in the last two years, climbing from around $3.40 a gallon (not California!) in early 2022 to $5.03 in July of 2022. This year they started at $3.44 rose by 15% to $3.95 in September and are now back at $3.44. People are quick to notice gas prices because it’s a purchase made 39 million times a day and at least once a week by 233 million drivers. So, we’d expect gas prices to be a key driver of consumer expectations and it turns out they are, especially for the University of Michigan survey.

We’ve taken the 12-month change in gas prices and overlaid it with the 12-month change in the confidence index. If the gas line (green) goes up, it means prices are falling.

It turns out they lead changes in the confidence survey by about a month. In September and October, people were experiencing around an 11% rise in gas prices. So, memories were fresh when they filled out the survey. The good news is that prices have fallen by around 17% since then, which suggests the next reports should be improved.

Second, there’s a wide divide between how people view the economy. Here’s the confidence survey by political party.

Republican respondents saw a big jump in confidence in 2016 but then a 75% decline from 2020. The jump in Republican confidence was much bigger than the fall in Democrat’s confidence. That reversed in 2020, with Republican confidence falling much faster that the rise in Democrat confidence. From the middle of last year, both lines are flat but spiky, and the Republican line is consistently gloomier.

So, coming back as to why the Conference Board and University of Michigan lines are more apart than they should be is probably because of gas prices, which carry a bigger weight in the Michigan index, and, possibly, because Republican voters are overrepresented in the same index. We know they’re more downbeat but they may also be a larger part of the survey.

Either way, we’re not overly concerned. Recent changes in gas and stock prices should raise the scores. Overall, inflation is moderating and unemployment low, both of which will drive survey responses. We’d expect better numbers in the next few months. But they sure can move around a lot.

Why Are Bonds So Volatile?

Oof, yes, we get it. Bonds are meant to be the steady part of the investment world but the last year and a half have led to some big swings in bond prices. Here’s a quick measure of the year-to-date 90-day volatility on options for two large ETFs: the SPDR S&P 500 (SPY)in blue and the iShares 20-year Treasury Bond ETF (TLT) in green.

For most of this year, and especially following the collapse of Silicon Valley and First Republic Bank in March and again last month, the volatility of bonds has been significantly higher than equities. We’d offer a few reasons why.

Feel free to skip to the last paragraph of this section for the summary. The next sections get into some money market plumbing, which is not everyone’s idea of a fun time.

The Technical Stuff

First up is the U.S. Treasury, which from February to June, drew down its balances at the Fed – or the Treasury General Account (TGA) – from $560 billion to near zero. After the debt ceiling resolution, it built the account back up to $820 billion.

The TGA is sort of the Treasury’s checking account from which it pays its bills and salaries. It never used to be much above $5 billion until the GFC. Back then the Fed would use accounts at private banks to deposit things like taxes and to pay bills. Those inflows and outflows were somewhat stable so the banks had predictable balances and no need to adjust reserves. Bank reserves were largely stable.

But this all changed in September 2008 when a major money market fund and then AIG needed $148 billion in one day. Several programs, along with many acronyms like SFP, IOER, and TT&L, then went into effect (the full list is here). The upshot was that the Fed started paying interest on the TGA and the Treasury moved its cash out of the banking system and into the Fed.

Three major benefits followed. One, the Treasury was protected against overdrafts, two, it earned more interest and three, the big inflows and outflows no longer got in the way of monetary policy.

As 2023 came around and the debt ceiling negotiations heated up, the Treasury was unable to borrow and the TGA balance dropped like a stone. This put money into the economy. After the debt resolution, the TGA climbed by $800 billion, taking money out of the economy. The $820 billion today sits inert at the Fed and will stay that way until the Treasury starts to spend it. The swings in the TGA since early 2022 and into 2023 are unprecedented. The effect on the market was to push out and then pull in a lot of cash. The bond market managed to keep up but it certainly didn’t help volatility.

Second is the reverse repo operations facility (RRO) at the Fed. Money market funds (MMF) grew from around $3,500 billion in 2019 to $5,700 billion today. Around $1,000 billion of that was just this year. Money market funds typically take in cash and invest in short-term Treasuries and securities. But they can also go to the New York Fed with their cash, deposit it overnight and receive treasury securities in return. They then receive interest on those securities overnight at the Reverse Repurchase Rate (RRR), which tracks the Fed Funds rate . In the morning, they deliver the securities back to the Fed and the Fed gives them cash. The same evening, the process is repeated.

The Fed has plenty of Treasury bonds and bills from years of quantitative easing and was only too happy to help. For most of 2022, the interest on the overnight RRR, was higher than T-bills and, just as important, it was at rates that adjusted daily. The Fed was raising rates at nearly every meeting through 2022 and 2023 so it made sense for MMFs to use the floating RRR rather than lock into low yielding T-bills for three or six months. The RRR facility at the Fed thus grew from around $1,500 billion in early 2022 to $2,500 billion in early 2023.

Now the Fed is probably done with rate hikes, so the RRR has steadied at 5.3% and 4-month Treasuries yield 5.5%. The MMF managers now feel confident investing for a longer period and pick up a rate gain. The RRR balance is now down to $914 billion and heading south.

As with the TGA, the big swing of $1,500 billion in eight months into and then out of a Federal Reserve account meant a lot of money movement. And that didn’t help volatility either.

Portfolio Management

This year has been a good year for the “basis trade.” This is when portfolio managers, usually hedge funds, arbitrage between the cash and futures prices of a Treasury security. A futures price may trade above the current price of a bond, in which case, the hedge fund manager will buy the bond at the lower price and sell the futures at a higher price. Yes, the fund is shorting futures. And yes, that’s always risky.

But these price differences are tiny and to make the trade work, hedge managers borrow cash to multiply the bets. Hedge funds are not regulated as Treasury dealers so they can borrow up to $50 for every $1 of cash. They also trade between themselves. No one really knows how much! Even the U.S. Treasury warned that it’s a regulatory blind spot. But it’s likely that with all the rate increases, the “basis trade” has been very active in 2023. We know that leveraged funds accounted for around 50% of all short treasury positions last week and that their short positions are eight times larger than their long positions. Some weeks this year, they’ve accounted for nearly all the short positions. Last week they held 735,209 short contacts on the 10-Year Treasury with a notional value of $735 billion! That’s a lot of money at stake.

We’re not, and neither is the U.S. Treasury, sure how this contributed to volatility but it’s worth a lot of money to the hedge funds. One major manager kicked up a big fuss at the thought of any regulation. In 2020 we saw a big unwind in the basis trade and it led to major instability in the treasury market. It’s these basis trades contributed to volatility this year.

The Fed and Everything Else

The Fed, of course, has raised rates very quickly. At the same time, it removed itself as a buyer of treasuries back in 2022, reducing its treasury holdings from $5,771 billion to $4,800 billion. So that’s around $1,000 billion of bonds that needed a new home.

The U.S. Treasury also announced new supply of bonds and bills to finance the deficit a few months ago. In the second quarter of 2023, issuance of coupon bonds, which are bonds with maturities of over two years, was around $798 billion. In the third quarter it dropped to $671 billion. But in the fourth quarter, with the Treasury allowed to borrow again, it’s expected to be $920 billion. In the first three months of 2024 its issuance is expected to be $984 billion. The market can absorb the new issues but the variability caused by the debt ceiling led to some unusual surges.

Finally, we’d lump everything else into changes in inflation, the Fed’s hawkish September “higher for longer” announcement, the concern about the bond sell-off in October and the uncertainty about whether the Fed was done or not.

In Summary

Bond market volatility remains high. In the last six months, the iShares Treasury fund (TLT) has moved between $82 and $104 or a 26% range. The S&P 500 range has been around 11%. But as the Fed’s intentions clarify and if inflation and the employment numbers come in at the expected levels in the next few weeks, we’d expect bond volatility to settle down. It’s been a rough 22-months but the end seems in sight.

Europe’s Export Boom

We’ve mentioned a few times Europe’s export bonanza to some out of the way places like Armenia, Tajikistan, Kyrgyzstan and Uzbekistan. We haven’t seen EU-wide numbers since July, but at that point, EU exports to the Commonwealth of Independent States (CIS) a loose group of trading partners from the ex-Soviet states but excluding the Baltics, were up 82% over the year. Of course, no one’s fooling anyone. This has nothing to do with some economic boom in any of the states and all to do with EU exports re-routing through the CIS to Russia. Or to put it more crudely:  sanction busting.

Some of the numbers are updated. Here’s a good one.

It shows German and Chinese exports to Kyrgyzstan where Germany has increased exports by 600% to around $60 million a month and China by 400% to $180 million a month. In 2021, German exports to Kyrgyzstan were $48 million and this year are already at $534 million with another three months data to go. For China, exports in 2021 were $748 million and are now running at $2,093 million.

It’s not just Germany and China. The list goes on.

U.S. exports to Kyrgyzstan were $109 million in the year to September, up from $35 million in 2022. The UK sent some $88 million of goods to Kyrgyzstan in the year to June 2023, an increase of 270% from the prior period.

And what were they selling? There’s the rub. The list of sanctions against Russia is meant to include anything to do with technology, energy, aviation and so-called “dual use” goods that can be used for military and civil purposes. It’s meant to cover things like drones, software and encryption technology.

But “dual-purpose” is an easy workaround if you’re really determined to sell to Russia or its entrepots like the CIS. Dentist drill? Yeah, sure. Who doesn’t want healthy gums? But a dentist’s drill uses some pretty sophisticated gyroscopes which can also work in guided missiles. Night vision and thermal imaging devices can be bought by any keen naturalist but they’re also used for military night-sights and GPS systems.

The UK for example has sold a lot of generators, non-car vehicles, and specialized machinery. But it’s anyone’s guess how they’re used, broken up and re-purposed.

Overall, Kyrgyzstan’s imports run at about $2,400 million or 18% of GDP, up from 11% in 2021. The U.S. by comparison is around 13%. Kyrgyzstan reports its imports from places like Germany, but they don’t match what Germany says it sells to Kyrgyzstan. There just seems to be a lot of stuff that disappears from the official records. It doesn’t take much deduction to figure out that it ends up in Russia.

It’s not just Kyrgyzstan of course. Chinese exports to Belarus are up 200% in the last year to $5 billion a month. Turkey’s exports didn’t even use the Kyrgyzstan/Armenia back door but went direct to Russia. It’s exports of goods to Russia were $158 million in the first nine months of 2023, up 200% in a year. Turkey doesn’t make many of the precision goods, microchips, communications equipment of telescopic sight it sells to Russia. It imports them directly from the EU. The value of those imports is up 60% from pre-2022 levels.

So, trade patterns have gone nuts across Central Asia, the CIS and Russia since sanctions began. Are sanctions a waste of time? And does it really matter to U.S. investors?

In answer to the first, we’d say no. Some of the sanctioned trade gets through but at a higher price and with a long bureaucratic work around. All sanctions are leaky and while they may not close down trade, they do make it very inconvenient.

Second, it matters because of oil.

A major sanction against Russia is the price cap of $60 a barrel on any oil exported from Russia. The price cap went into effect in December 2022, when oil was $89. Since then, it’s fluctuated from $68 to $94 and is currently at $75. The sanctions mean that any oil bought from Russia cannot travel in G-7 and EU ships. Nor can those ships be insured, cleared, crewed or unloaded in any EU or U.S. domain. There have again been many workarounds, particularly among Greek and Cypriot ships.

But enforcement is stronger now. Just this week, three Greek shipping firms stopped transporting Russian oil. Similar actions are coming for ships from the UAE and Turkey. The Greek actions alone cut some 100 oil tankers from the roughly 600 tanker trading fleet needed by Russia.

The result is that Russia faces increasing production and transport costs. What used to be piped to Europe now must go in older and smaller ships all the way around the Cape of Good Hope to Asia. The additional costs are around $10 to $16 a barrel. The break even cost for Russian oil is around $44 and headed up. Russia will try and sell as much as it can to finance the war.

That’s intended to be and is a hardship for Russia. But it means that global oil prices are coming down. If India, for example can buy Russian oil at less than $60, it will. But if the global price is $75, it might just decide to avoid the hassle and resume buying from the middle east.

All this is playing out in real time. But our take is that, yes, the trade export sanctions are far from perfect but the oil sanctions are slowly working. Russia will pump and sell all it can. It can’t afford to stop. That should mean plenty of oil and probably at continued low prices. That should help the U.S. inflation outlook.

The Bottom Line

The market is in a “good news is good news” frame of mind. This week alone the third quarter GDP report was revised up from 4.9% to 5.2%. Nominal GDP is 6.3% above the levels of a year ago and grew by $1,650 billion. The PCE deflator, the all-important inflation number followed by the Fed, came in at 0.0% for the headline and 0.2% for the core. On an annual basis the core PCE was up 3.5% which is the slowest since Aprila 2021. Inflation in the EU was also lower than expected. All good.

We also saw several Fed speakers with most of them seemingly satisfied with the progress on inflation. The clearest point came from Governor Christopher Waller, who said in the Q&A session:

Even OPEC+’s announcement that it would cut production by 2.2 million barrels a day or 3% of daily global demand, failed to worry markets. The price promptly fell by 5% to around $75.

The next few weeks bring some market moving data, with the jobs numbers, inflation and the Fed’s last meeting of the year on December 13.

Bonds rallied strongly all week but at 4.3%, the drop in the 10-Year Treasury rate is probably done for now. All the major U.S. equity markets, including the tech-heavy Nasdaq, the S&P 500 and small cap stocks, are up around 10% over the last month. European and Japan stocks are also up by 7% to 8% but that comes closer to 10% given the dollar’s recent, and probably overdue, weakness.

We’re entering the final rounds of trading for the year. There’s a lot of portfolio positioning for yearend reporting and probably some locking in of gains and last-minute tax-loss harvesting for bond funds. But as we mentioned two weeks ago, we expected year-end rallies and they should remain strong.

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Art: Joan Mitchell (1925-1992)