Hot growth for a soft landing

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Thanks for having me back, Unhedged readers. In yesterday’s newsletter, Ethan covered this week’s Fed meeting, pointing out that chair Jay Powell held off from celebrating the improvements in inflation we’ve seen in recent months. I think that was probably strategic on his part. Stocks are up and credit spreads are tight, despite the fact that we have the highest interest rates in 22 years. Any sign from Powell that the Fed is done raising rates would have sent those riskier assets through the roof, loosening financial conditions further and making the Fed’s job harder. 

Today, I’m exploring how that Fed decision jives with some hot US GDP data that came in yesterday and whether a soft landing might actually be in the cards for those of us on the better side of the Atlantic. 

I also explain why I’m a bit worried about the big surge in Treasury bond issuance we’re expecting to see later this year. I promise I’m not a budget hawk; I’ve just been writing about the Treasury market for a long time, and its embiggening since 2008 has created financial stability risks. Complain, if you’d like, here: kate.duguid@ft.com.

GDP

The US economy grew 2.4 per cent on an annualised basis in the second quarter, the Department of Commerce reported on Thursday, well above the 1.8 per cent that economists surveyed by Bloomberg had forecast. It’s also above the 2 per cent growth rate in the first quarter. Consumer spending did slow after a surprisingly strong start to the year, but the dip was more than made up by business investment. 

Strong economic growth, a hot labour market and slowing inflation sounds like a scenario in which the Fed could get its soft landing — a slowdown in inflation without an economic crash. A soft landing may be even more plausible if the Fed stops raising rates now, a possibility that Powell seemed open to this week.

James Knightley, chief international economist at ING, wrote that decent growth, with slowing inflation — plus weekly jobless claims falling — have “further helped boost the soft landing narrative”. Here’s ING’s nice chart on the various contributions to GDP:

Market reactions were mixed — stocks were slightly lower, while the 10-year Treasury yield, which moves with growth expectations, rose quite a bit.

But many are struggling to enjoy the good news. Eric Hickman at Lantern Capital noted that it is normal for GDP to be strong ahead of a recession. In July 2000, second-quarter GDP was 5.2 per cent (above survey expectations of 3.8 per cent), and the recession began eight months later in March 2001. In October 2007, third-quarter GDP was 3.9 per cent (above survey expectations of 3.1 per cent) and the recession began two months later.

The long and variable lags of monetary policy still loom over the market. Kristina Hooper, the chief global market strategist at Invesco US, said:

It seems likely that the trajectory we are on is one in which we have a bumpy landing. I’ve never been in the hard landing camp. But I’m reluctant to say we’ll get a soft landing. We have not seen most of the impact of the aggressive Fed tightening. The rule of thumb is a 12-18-month policy lag between when policy is enacted and when it shows up in the real economy.

Hooper thinks we will avoid a job-destroying hard recession, given the strength of the labour market, but is suspicious that growth and credit conditions can remain this buoyant.

Treasury issuance, again

If the Fed is done raising rates and inflation is slowing, one obvious trade is to add longer bonds to your portfolio. Investors had been avoiding duration for a while, deterred by high inflation and very fast rate rises. Short-dated bonds’ hefty coupons looked inviting by comparison. But as Rob wrote recently about the 10-year Treasury: “If we are on the way back to normal after a bout of supply-shock inflation, then locking in a 3.8 per cent yield for 10 years — when pre-pandemic long yields were quite consistently below 3 — seems like a logical bet.”

Some evidence suggests investors are doing just that. Asset managers are near the longest net position in 10-year Treasury futures on record, according to Commodity Futures Trading Commission data:

The Bank of America rates and FX sentiment survey likewise suggests that US investors have reached an almost 20-year record in exposure to duration:

But there’s one looming risk to loading up on all that duration.

The last time I did Unhedged, I wrote about the danger to markets from a coming flood of new Treasury bills. That worry has largely failed to materialise. The Treasury bills issued so far appear to have been bought up by money market funds. This neutralises the impact to the financial system. The cash going to buy the fresh Treasuries originated outside the financial system — in the overnight reverse repo facility — and is staying outside the system — in the Treasury general account. 

But there’s another flood of Treasury issuance that could cause problems for the market, in particular for all those investors piling into longer-maturity bonds. 

While the Treasury has so far leaned on short-dated bill issuance to raise cash, it is expected to announce next week an increase in the amount of longer-dated bonds it will sell for the first time since 2020. Mark Cabana, head of interest rate strategy at Bank of America, cautioned that the US will need to borrow more money later this year to fund fiscal programmes, which will amount to selling a net $535bn in two- to 30-year bonds between July and December.

“There are a few indicators showing that the market is long duration. We think that is sensible,” said Cabana. “But that is a well-subscribed view. It appears to be the consensus view. And markets tend to surprise.” 

A rush of long-dated bonds hitting the market could push up yields, not only upending the long-duration trade, but raising borrowing costs for US companies, too.

In the best-case scenario, this increase in supply is easily absorbed by the market, leaving yields mostly unchanged. That may not happen this time, however, because many natural buyers of long Treasuries have left the market. The Fed is shrinking its balance sheet, deposit shrinkage has cut commercial bank demand for Treasuries, and foreign buyers are put off by high currency hedging costs. Lower demand may mean Treasury prices have to come down. 

Why wouldn’t the investors who want to bet on long duration buy up all that fresh long-dated debt? First, it’s not clear the demand for long duration is deep enough to absorb the supply flood. And second, more supply will continue to hit markets for months, during which time the long duration trade could start looking far less enticing.

One good read

Swifties are a symptom of years of low interest rates.

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