Three yield curve outcomes and grey swans

I am in an even more hopeful mood now than ever. But, at the same time, I still have my worries about downside risks given how euphoric asset markets have been and how mediocre economic data have been. I think that split between hope and risk is a good way to frame this update to my three yield curve scenarios. And so I want to start out with the biggest new risk first.


Here it is:

“despite the many people who have already been infected with SARS-CoV-2 globally and are presumed to have accumulated some level of immunity, new variants such as 501Y.V2 pose a significant re-infection risk.”

That’s a direct quote from an article about a South African study on the mutant coronavirus strain dominating viral confections there. The long and short here is that it’s not 100% clear the 90%+ effectiveness of existing vaccines will hold with the mutant strains of COVID-19 now proliferating in places like the US, Brazil, South Africa, and the UK.

Now, note that Pfizer and BioNTech have done a study and released a paper showing their vaccine will be effective against the British B117 mutation.

But, in the Guardian newspaper, this was the conclusion:

Danny Altmann, professor of immunology at Imperial College London, said the latest results were “disturbing” and could impact vaccines. “You need to pose the hypothetical question: are these effects big enough to subvert protection by the current vaccines? My current prediction is that, faced with the South African mutation, though probably not for B1.1.7, the answer would be yes,” he said.

Framing the mutations

Here’s how I’m thinking about this in the context of the economy. The coronavirus pandemic was a black swan event that came totally out of the blue. It completely blindsided us and was so significant that nothing policymakers could do would have prevented some measure of global economic devastation.

But once the coronavirus hit and reached pandemic status, there were a lot of known unknowns, grey swans, if you will. For example, here’s how I put it regarding mutations back in March 2020 before the lockdowns were going into effect:

There’s one other thing to remember about this pandemic. We do have two separate strains now. So, we have had virus mutation. And so far, there’s no evidence one strain is much deadlier than the other. But that’s not necessarily how it will stay. The lesson of the 1918 great influenza pandemic is that mutation can make a virus return much deadlier months later.

I would posit that the recent mutations in South Africa and the UK are more deadly given that they are more infectious and no less lethal. For example, in the UK, we saw over 1800 deaths yesterday with lockdowns failing to prevent R-factors from rising. So, it seems that the infectiosness is driving extreme outcomes both in terms of infections and death despite a lockdown.

Given my repeated reference to this possibility of deadlier mutation last Winter and Spring and the fact that I am no expert in infectious diseases, it’s clear that the UK and South African outcomes were a known unknown. The longer the crisis lasted and the more uncontrolled the spread, the greater potential for deadlier mutations. And now they have arrived.

Grey Swans and the economy

We have vaccines now though. So the way to think of these grey swans is as a race against time. The less effective the vaccine rollout, the greater the chance that the vaccines will be less effective against mutations. And the less effective they are, the longer it will take for us to reach a new post-pandemic normal. We will get there eventually. The question now is how long it will take and what that new normal will be.

So I would frame the economic risks this way:

  1. How long is the economic tunnel between now and the post-pandemic period compared to what’s ‘priced in’?
  2. How does the economy develop between now and then?
  3. How do markets develop in that time period?
  4. And what is the new normal relative to current expectations?

In terms of the first risk factor, if the tunnel lengthens enough, it could undo the reflation trade that has everyone looking through mediocre economic data. If people are thinking the new normal is Fall 2021 when it later turns out to be Spring 2022, that’s enough of a difference to matter both to the economy and to markets.

On the second risk, even if the tunnel length is as we expect it to be, the economy in the tunnel period may be different than we expect. Growth could be lower or higher. Unemployment could be lower or higher. And bankruptcies and credit writedowns could be lower or higher. I would say this probably matters less than the first risk because people are already looking through this period as a temporary aberration. And so, they can continue to do so. But for some individual companies with a lack of scale, with poor balance sheets or in pandemic-affected industries, this matters greatly.

I think the rubber hits the road on this in terms of how markets react. I gave you three bond market outcomes. And I think they cause different equity market outcomes as well. In a flat curve environment, cyclicals do poorly and the overall market may sell off. In a steepening environment, cyclicals may do better while the overall market sells off. And in a hold, we can continue to bet on reflation. That’s my first order cut between the three.

But, having said that, there’s one last variable that outweighs all of this; and that’s the new normal. If the high growth, pent-up demand outcome does not materialize, it’s telling us that growth is lower for longer. In that case, there’s no reason to bid shares up in anticipation of blockbuster earnings. And the reflation trade will be seen to have been a false dawn. This would be the worst outcome. And it is still months ahead before we find out what happens. We should be prepared either way

My view

If you asked me where I lean now, it’s away from the sharply steepening yield curve. I see growth as weak enough now and for the rest of the pandemic to prevent that outcome. Inflation is a concern. But on the whole, I do not expect inflation to create steepening.

The bigger question is what happens when we get out of this. And I am not only hopeful that the pent-up demand scenario plays out, I lean toward believing that will be the outcome. So I have sympathy for the reflation trade. Directionally it makes sense. But the price action has been so over the top, you have to believe we are in for a bumpy ride before we get to the end of the tunnel.

Good luck. Stay safe

P.S. – My mother got her first vaccine shot this past weekend.

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