The ‘interregnum’ of risks to the upside as yields turn down

Just now, I was looking through the Credit Writedowns archives, searching for the phrase “to the upside” because, today I am thinking about risks being upside risks rather than downside risks. The data released this morning confirm that. But what does it really mean that risks are to the upside”? Let’s walk through that today.

Glass half-full

As you know, I was a glass half-full guy as the new year began. And I said so in my first post this year. But as the year began, I was still in a risks ‘to the downside’ frame of mind, worried about the third wave and the mutant viruses and their impact on the economy and weakened businesses in the pandemic-affected sectors like travel, retail, hospitality and leisure.

I had laid out the medium-term bullish case in December for you. But that pre-supposed an awful Winter with the attendant risks. That awful-ness arrived, but we saw it in the EU and the UK and not in North America. Plus the Q4 2020 results after the US second viral wave were good enough to tell us by February or so that the coast was mostly clear.

That meant that Q1 was a full-on power move toward re-opening with yields up, bank stocks up, small cap stocks up, cyclical stocks up, value stocks up and industrials up. The results from JPMorgan Chase this week highlight how much less credit carnage we have seen than anticipated as they were able to reverse billions of loan losses en route to a record quarter. The only downside was that the move in Treasuries was so abrupt that it ended up hurting tech and growth stocks by February.


But that’s all changed now. Tech stocks bottomed when 10-year US Treasury yields confirmed the breakthrough above the 1.50% trading range in the first weekend in March over a month ago. And we can look back with hindsight at that point marking a phase shift in economic and market sentiment.

Ever since then, we have been in a trading range below 1.75%. The market has tried to break out the range twice since then, once up to March 18 and again on March 30. Both times it failed to consolidate above 1.75%. And now, as I write this, the 10-year is trading down to 1.569%, making you wonder whether the 1.50% breakthrough sticks.

The obvious question is: why is this happening? Literally this week we got off the charts high numbers on consumer price inflation and import prices. And ostensibly, it is the inflation bogeyman which would prompt the Fed to raise policy rates ahead of their forward guidance, justifying the uptick in yields. Yet, no sooner have we seen these numbers and the yield backs off, down from 1.693% on Tuesday. This is pretty remarkable.

The economic numbers out this morning were all stellar – a quadrifecta of US economic goodness.

  • US retail sales up 9.8% month-on-month vs. 5.9% expected
  • Initial jobless claims at 576k vs 700k expected and solidly below previous cycle highs for the first time during the pandemic
  • US Empire Manufacturing Survey for April at 26.3 vs 19.5 estimated and 17.4 in March
  • Philadelphia Fed April Business Index 50.2 vs. March 44.5

All of this is pointing to risks ‘to the upside’ in my view. Yet the market is acting like we are back to the long growth stocks, long US Treasuries paradigm of 2020.

Mentally, I am thinking of this as an interregnum period as we await the full post-vaccine re-opening. And so, I am waiting to see what any of this means about market sentiment or market and economic risks.

Risks to the upside

So that gets us to this phrase ‘risks to the upside’ that I keep banging on about. If markets and the economy have upside momentum, why are there any risks at all? That might be your question. My answer is that the biggest risk of upside momentum is overheating. And overheating leads to crash up and crash down scenarios, which are some of the worst outcomes. This is how the 1990s ended. And it’s also how the US housing bubble ended in 2007.

Now, we’re used to thinking about that end as policy-induced, meaning the end is a byproduct of policy tightening by the largest central banks. And in this cycle, we are in a doubly unique position because the upside risk is developing at the beginning of the cycle, and the Federal Reserve is not leaning against it. So it’s hard to handicap outcomes given the unprecedented nature of a pandemic, large fiscal deficits and loose monetary policy goosing a bullish market and economic situation. But I think the risks are clear. We could move so far to the upside – or we could already have moved so far to the upside – that the only likely outcome is a crash up and crash down. And that’s irrespective of policy support.

So when I talk of risks to the upside I mean it in the traditional policy sense where the central bank and/or fiscal authorities see market excesses and/or inflation and move against it. Again, policy makers are resisting the urge to move in part because the mutant virus wave is still a virulent threat and in part because we haven’t fully vaccinated yet.

My View

So, for the time being, I am looking at the present phase a ‘free pass’ period, where the data don’t really matter. Only momentum matters. And I believe we can sustain this interregnum period up through the start of summer, by which time the US will be nearly fully re-open and inflation comparisons to 2020 will be meaningfully absent of lockdown-associated disruption.

In terms of the economy, eventually expectations will catch up with reality. But I believe near term data will continue to surprise to the upside until economists recalibrate. And that will last through the interregnum until Summer.

In terms of markets, the momentum is back with tech, though some value plays can catch a bid too (see here). And the Coinbase public listing gives more upside to tech. You might even say we’re entering a blow-off top frenzy as I contemplated at the end of February. The key difference to my thinking now is that rates have stabilized and even receded without any Fed intervention necessary – no YCC, no threatening forward guidance – nothing. That’s very supportive of the current momentum higher. But,as Hyman Minsky might say, this is the kind of stability that breeds instability.

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