Last Friday, the DJIA, S&P 500 and NASDAQ all closed up. But too big to fail banks lost billions of dollars in market cap.
Among the biggest losers were Citigroup — closing down 1.7%, Credit Suisse — down 1.6%, and Deutsche Bank — down 1.3%.
In the second tier, JPMorgan Chase, Barclays and Goldman Sachs closed down between 0.1% and 0.4%.
Their problem appeared to be the flattening of the Treasury yield curve.
By Dave Allen for Discount Gold & Silver
Last Friday, the DJIA, S&P 500 and NASDAQ all closed up. But too big to fail banks lost billions of dollars in market cap.
Among the biggest losers were Citigroup — closing down 1.7%, Credit Suisse — down 1.6%, and Deutsche Bank — down 1.3%.
In the second tier, JPMorgan Chase, Barclays and Goldman Sachs closed down between 0.1% and 0.4%.
Their problem appeared to be the flattening of the Treasury yield curve.
As explained by Pam and Russ Martens, the longer out an investor goes on the yield curve (i.e., the longer a bond’s maturity), the higher the yield.
That’s unless the yield curve flattens or inverts (with an inverted yield curve, the shorter a bond’s maturity, the higher its yield).
And as the Martens point out, that typically means the Fed has either already begun tightening monetary policy by starting to hike interest rates or is expected to begin hiking them shortly.
More importantly, “the market perceives that the Fed is going to over-shoot and bring on a recession.”
And so, short rates inexorably rise (because of the Fed tightening) and longer rates fall (because investors see the tightening resulting in slower or negative growth in the economy).
If you land on the wrong side of that trade, your wallet can get hammered.
Hedge Funds Also Losing Big Bets
Bloomberg News and other media outlets reported on Friday that hedge funds lost significant sums in wrong-way interest rate bets.
A rapid flattening of the yield curve in major global bonds is behind losses for some of the biggest macro hedge funds.
One of them, Chris Rokos’ hedge fund, has lost 11% in October — partly because of bets that the difference between short- and long-term U.S. and U.K. government bond yields would widen.
But they haven’t; they’ve tightened.
That may account for Friday’s Sea of red ink in the shares of the Wall Street banks, which provide leveraged loans to hedge funds through their prime broker operations.
The yield curve of U.S. Treasuries hasn’t yet inverted, but it’s flattening — with a lot of that flattening occurring last week.
As the charts above show, as June got underway, the 5-year Treasury bill was yielding just 0.8%, while the 30-year Note was yielding 2.3% — a spread of 1.5 percentage points.
In other words, the investor was getting paid nearly 3 times more (1.5 percentage points) to invest 25 years longer.
But as of last Friday — almost 5 months later, the yield curve had flattened to such an extent that the spread between the 5-year and 30-year bonds had narrowed to just 0.75 percentage points (1.19% vs. 1.94%, half the spread of early June).
Buzz last week from the Bank of England and the Bank of Canada — that rate hikes are coming sooner than previously expected — was also giving yield traders agita.
Brazil’s central bank lifted its key interest rate by 1.5 percentage points last Wednesday — a half point more than expected by market watchers and the largest percentage increase since 2002.
If short-term Treasury rates continue to spike here this week (they were unchanged today), it could mean that hedge funds have more short-term Treasury notes to dump to limit their drowning values.
How Will the Fed React?
Certainly, last week’s yield curve flattening is bringing increased focus on the Fed’s two-day policy meeting that starts tomorrow and conclude Wednesday afternoon, with Jerome Powell’s press conference.
As of today, the Fed is expected to announce on Wednesday afternoon a specific timetable for starting to taper its $120 billion monthly purchases of Treasury securities and agency mortgage-backed securities.
Powell’s statement about when any interest-rate hikes and the Open Market Committee’s views on inflation can also be expected to move markets.
As we reported on last Thursday’s Financial Survival podcast/radio show, traders see a 65% chance of the first hike coming in June 2022 — with the second coming as soon as September (51%) and a third in February 2023 — according to the CME’s FedWatch tool.
As inflation escalates beyond the transitory phase, traders expect a more aggressive response from the Fed than its policymakers have been suggesting.
We’ll see on Wednesday how that perspective has changed. The most recent hike probability for December 2022 was 45.8%, but it went above 50% earlier Friday morning.
The switch in investor sentiment comes with inflation as measured by the CPI, excluding food and energy, increasing 4% year over year, and up 3.6% as measured by the PCE.
That 0.4 percentage point gap between “core” CPI and PCE, the latter being the Fed’s preferred measure, is likely to expand in the coming year due to rising housing prices.
A gauge of shelter costs that measures the level of rents property owners could get for their dwellings makes up almost one-quarter of PCE (23.6%),
It’s part of the overall shelter category that comprises about one-third of the popular inflation gauge.
While owners’ equivalent rent increased just 2.9% on a year-over-year basis in September, it’s expected to accelerate into 2023 and broaden the gap between CPI and PCE.
And with inflation measures rising higher than expected and GDP growth increasing smaller than expected, the prospect of stagflation and declining real interest rates should make gold and silver a prudent investment in the days, weeks and months to come.