August 2011 inverted: Here Comes the Rate Shock and YCC

Yesterday, I posted The 2s10s Ratio Says Achtung Baby. See that for more details on the charts below, including seeing how the 2011 pattern on the 2s10s ratio looks very similar to the current patter, complete with what looks like a double-top failure as in 2011 at the same horizontal.

History is rhyming with 2011, but there are differences along with similarities. The Federal Reserve ended its QE2 policy in June of that year. A slowdown in Chinese real estate appeared that some month. Real estate rage showed up in October 2011. Back then gold was surging into its peak as people believed the establishment lie that USG would default on its debt if the debt ceiling wasn't increased. Inflation sentiment was peaking then, it is rising now because people are worried USG will run up the deficit for years on end. It could peak if the Fed lets rates rise and doesn't implement any YCC. Chinese growth had peaked then, but that wouldn't become clear until 2014. Chinese growth is slower than expected this year as well.

This time gold is down, but crude and stocks are up. One consistent theme is the U.S. Dollar Index is rising. While I date the bull market's start to June 2014, the dollar did make a post-2008 low in May 2011 and then failed to make a new low at the end of August 2011. If the dollar repeated its run from Sept 2011-July 2012, the DXY would be at a new bull market high by the end of this year...defintely somethhing to keep an eye on. (I've discussed dollar targets in recent posts.)

The 2-year and 10-year yields are at the same level they were at back then, producing the same ratio. What's different is both the 10-year yield and 2-year yield were bottoming because as happened with each ending of QE, rates and risk assets were sinking. Broad market indexes hit all-time highs on Thursday. There's also no indication the round of QE begun in September 2019 is ending. Instead, the Federal Reserve has hinted it will escalate with yield curve control. (Of note, the Fed started talking up YCC right around the time 2s10s ratio was first hitting the 2011 level in February, right before the Nasdaq started selling off.)

Other inverse factors include the Nasdaq and other assets selling off in response to higher interest rates as well as the end of lockdowns. Investors aren't buying up bonds, they're selling. The 10-year and 2-year yields are both threatening to complete or break out of their bases. The 10-year would target to around 3.5 percent if it moves through 2 percent, a slightly higher rate than where it peaked in 2018. In 2011, central banks intervened to revive animal spirits. Rising yields were good news. This time, the Fed doesn't want short-term yields rising along with optimism and inflation expeectations. Given statements by Fed officials, it will step in and suppress the shorter end, which I suspect includes the 2-year yield. Intervention could come sooner than expected because the chart says a quick move to 0.50 percent area is likely. After that, there's no signficant resistance in the 2-year yield until the 1.50 percent area.

The time for the bond vigilantes to call the Fed's YCC bluff has arrived. And why not? The Federal Reserve has said transitory inflation is coming. Why shouldn't bond holders demand more interest on their short-term loans? The February 2021 CPI was 2.8 percent higher than May 2020. The survey data indicates prices are accelerating, but only a steady rise from February gives a headline CPI of 3.9 percent in May. If prices keep rising, where does the CPI peak even if only transitory? The 10-year TIPS bond maturing in January 2022 has a yield-to-maturity of 2.8 percent and the July 2023 bond 2.7 percent. It would be surprising if, absent somethinig like a substantial financial market correction, yields didn't resume their acceleartion right here. Moreover, it would make sense for the 2-year to rise faster than the 10-year as in 2011 and as is normal during an economic recovery. The Fed message has been clear though: this isn't a recovery yet, so short-term rates will stay low. Are they serious or not? Place your bets.