Down Under Daily, 13 July 2021

It’s too early to call the end of the reflation trade

It’s too early to call the end of the reflation trade. from being large net sellers of Treasuries last year
Bond yields are drifting lower due to technical to now substantial buyers (Exhibit 3).
factors and, perhaps, a mistaken view that the US is
near an inflation peak. But cycles don’t end without Exhibit 3

policy tightening, and in this cycle important central Foreigners swing from sellers to buyers
NET FOREIGN PURCHASES OF US TREASURIES
banks, including the Fed, will not tighten pre- 1000 500

emptively. That almost guarantees that there’s an 800

12M ROLLING TOTAL
400

600 300
inflation overshoot ahead that will lift bond yields.
400 200

200 100

US$BN
US long-end yields have drifted lower since April, in 0 0
my view largely reflecting several technical market -200
1 MONTH (RHS)
-100

factors. First, Treasury supply dried up as the Fed -400 -200

purchased almost all the net issuance of Treasury -600 -300

-800 -400
paper over the past quarter (Exhibit 1). 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025

Source: US Treasury, NBER; Minack Advisors

Exhibit 1
Fed soaks up all the Treasury issuance Third, the yield decline gained momentum as short
600
US PUBLIC DEBT ISSUANCE & FED DEBT PURCHASES
600 positions were covered (Exhibit 4).
NET ISSUANCE OF PUBLIC DEBT
500 US$BN, 3MMA 500
Exhibit 4
400 400

300 300
Short and caught
US$BN, 3MMA

DEBT ISSUANCE NET

OF FED PURCHASES SPECULATIVE POSITION IN US TREASURY NOTES & BONDS
200 US$BN, 3MMA
200 15 15
NET POSITION NON-COMMERCIAL HOLDERS IN FUTURES & OPTIONS AS % OF
OPEN INTEREST. 5, 10 & 10 YEAR ULTRA LONG NOTES; BOND & ULTRA BONDS.
100 100 * POSITIONS WEIGHTED BY SENSITIVITY OF FUTURES PRICE TO YIELD CHANGE.
10 10
0 0
% OF OPEN INTEREST

5 5
-100 -100
FED TREASURY PURCHASES
US$BN, 3MMA, SIGN INVERTED 0 0
-200 -200
2007 2009 2011 2013 2015 2017 2019 2021 2023 -5 -5

Source: Federal Reserve, SIFMA, NBER; Minack Advisors -10 -10

UNWEIGHTED TOTAL
-15 -15
Second, US long-end yields look attractive to foreign WEIGHTED TOTAL*
-20 -20
buyers. To a Japanese buyer, after hedging currency 95 97 99 01 03 05 07 09 11 13 15 17 19 21 23

and funding risk, the US 10 year yield was at its Source: CFTC, Bloomberg, NBER; Minack Advisors
highest level since 2016 (red line in Exhibit 2).
Fundamental factors may also have played a role.
Exhibit 2 First, on a short-term view, US macro data have
US Treasury yields look attractive to foreigners stopped surprising to the upside (Exhibit 5).
US & JAPAN 10YR TREASURY YIELDS
3.5 3.5
3.0
US 10YR
3.0
Exhibit 5
2.5 2.5 US macro data stop surprising to the upside
2.0 2.0
US DATA SURPRISES AND 10 YEAR TREASURY RETURNS
1.5 1.5 1.6 -20
* BLOOMBERG INDEX. † 13WK % TOTAL RETURN. TRUMP ELECTED
%

1.0 1.0
1.2 -15
0.5 0.5 DATA SURPRISE* (LHS)
0.0 0.0 0.8 -10
NET BALANCE

13WK % RETURN

10YR JGB
-0.5 -0.5 0.4 -5
-1.0 -1.0
US 10 YR HEDGED INTO YEN* 0.0 0
-1.5 -1.5
* ROLLING 3M FUNDING & FX HEDGES.
-2.0 -2.0 -0.4 5
11 12 13 14 15 16 17 18 19 20 21 22 23
-0.8 10
Source: Bloomberg, NBER; Minack Advisors
-1.2 15
US 10YR TOTAL RETURN† [INV]
-1.6 20
The same arithmetic applies to other potential 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023

foreign buyers. The result is foreigners have swung Source: Bloomberg, Bloomberg-Barclays, NBER; Minack Advisors

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Tuesday, 13 July 2021
Second, it is also almost certain that US growth and Exhibit 8
US inflation will inflect in the current quarter Much of the fiscal stimulus was saved, not spent
(Exhibit 6). Given base effects, June quarter GDP 22
US HOUSEHOLD INCOME, SPENDING & SAVING
* CONSUMER SPENDING PLUS
12

growth is almost certainly the peak for the cycle. 20

PERSONAL INTEREST PAYMENTS.
10
Not so, in my view, for inflation (more below). DISPOSABLE INCOME

US$ TR SAAR
18 8

US$ TR SAAR
SAVING
HOUSEHOLD OUTLAYS*
Exhibit 6 16 6

Growth and inflation about to inflect 14 4

US REAL GDP AND CORE INFLATION 'EXCESS' SAVING NOW 'EXCESS'
5.0 14
~$2½TR/15% OF SAVING
FORECAST GDP 12 INCOME 2
4.5 12 SAVING (RHS)
4.0 10
10 0
3.5 8 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023
3.0 6
4 QTR %

REAL GDP (RHS) Source: BEA, NBER; Minack Advisors

4 QTR %
2.5 4
2.0 2
FORECAST
1.5 0
1.0
PCE
-2 Second, it is not a tightening of fiscal policy to wind
CORE PCE (LHS)
0.5 -4 back income support payments as private sector
0.0 -6
-0.5
BLOOMBERG CONSENSUS FORECASTS
-8 incomes rise when the economy normalises. My
-1.0 -10
95 97 99 01 03 05 07 09 11 13 15 17 19 21 23 25 sense is that fiscal policy will remain supportive for
Source: BLS, BEA, Bloomberg, NBER; Minack Advisors growth even as the deficit falls next year.

Third, there may be some longer term concerns A few points about the outlook from here:
about policy risks. On fiscal policy, the budget
deficit is set to fall from 2022 onwards. The fiscal First, unless there is an adverse fiscal shock – or
thrust (the change in the budget balance) suggests perhaps another debilitating Covid wave – this
an unprecedented fiscal tightening (Exhibit 7). expansion won’t end until the Fed starts tightening.

Exhibit 7 Second, the Fed will only start to tighten when it

An exaggerated measure of the fiscal change sees inflation sustainably in its target range.
US FISCAL THRUST: CHANGE IN THE BUDGET BALANCE
8 8
Third, this guarantees that there will be a second
CHANGE IN STRUCTURAL BUDGET BALANCE AS PERCENT
OF POTENTIAL GDP. WITH IMF FORECASTS.
6 6
inflation wave. Unlike the current goods-driven
4 4
inflation uptick – which is about to peak – a second
% OF GDP

FISCAL TIGHTENING
2 2
wave is likely to persist, driven by factors like
0 0
labour costs or rents that typically trend.
-2 -2
FISCAL EASING

-4 -4 Fourth, at some stage the prospect of a second

-6 -6 persistent inflation wave – one that requires tighter
95 97 99 01 03 05 07 09 11 13 15 17 19 21 23 25

Source: IMF, NBER; Minack Advisors

Fed policy – will lead to higher long end yields. I
think that this will be a major theme for next year.
But crude fiscal thrust estimates miss two Ultimately – in 2023 or beyond – I expect 10 year
important points. First, much of the increase in yields to peak around 4%.
public sector deficits was matched by an increase in
private sector saving. In other words, the increase Fifth, the prospect of a solid GDP cycle – albeit one
in the deficit did not dollar-for-dollar feed into GDP now past its fastest four-quarter growth rate – and
growth, while the private sector now has a handy rising long-end yields, should provide support for a
financial buffer. The cumulative excess saving in second leg of the reflation trade in equity markets.
the household sector is now around $2½ trillion or My best guess is that the reflation trade will regain
15% of household income (Exhibit 8). momentum by the December quarter this year.

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Tuesday, 13 July 2021
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Tuesday, 13 July 2021