Our research into market sentiment is flashing a highly unusual “conflicted” state of risk signal, with a bi-modal probability distribution for hypothetical expected returns on 10-Year Treasury futures over the coming months. This type of probability distribution is typically associated with event risk. That is, there are two competing and conflicting scenarios that are being debated by market participants and both have meaningful chances of occurring. This shows up in our research as a two-humped expected return probability distribution which we call “conflicted”.
One of the possible scenarios in the bond market is whether the economy is rebounding quickly or not. Third quarter 2020 US real GDP is currently estimated by the Federal Reserve Bank of Atlanta’s “GDP Now” as being in the mid-30% range at an annualized rate. Dividing by four, this means an 8% or so recovery from the low point in Q2/2020 and brings the US economy some 75% back to its previous peak from the pandemic shutdown low point. And if more fiscal stimulus is added after the election, then some analysts are arguing that economic growth in 2021 will be solid and signs of future inflation will develop. For the US Treasury market, the combination of more debt supply from the Government and a whiff of inflation would argue for lower prices and higher yields.
The daily data we are tracking from airlines, restaurants, subways, and commuter railways indicate the economic recovery is stalling. We may now be entering a difficult new phase where the economic recovery is heavily dependent on the activities in which consumers are willing to engage. Consumers have not returned to restaurants in full force, and many restaurants have gone out of business, especially in formerly vibrant downtown business districts. International air travel remains limited. Domestic business air travel has barely started a comeback and most analysts expect companies to cut travel budgets in 2021 to half of what they were before the pandemic. Airline companies have announced they will be laying off workers. Commuter railroads are in dire financial condition due to the work-from-home mandates. Hotels and tourism companies are struggling to survive.
Adding to the pessimism, student loans and mortgage debt forbearance programs have postponed a crisis, but in no way solved it. Without more help from the government, the risks are rising for a setback in economic growth in 2021. The level of unemployment may remain elevated in the 6% to 7% range all through 2021.
This setback scenario with elevated unemployment is not a scenario for any material general inflation pressure. While real GDP may have come back 75% by end-September 2020, jobs are only 50% back. And, the weekly new unemployment insurance claims have stalled for around 837,000 per week for the last 10 weeks, which is not encouraging because it signals that layoffs are continuing at an elevated pace.
This not-so-rosy jobs scenario suggests the Fed would stay below its 2% target inflation rate. Under this scenario, Treasuries might rally and yields could fall even lower. There is no need for an inflation premium when inflation expectations are anchored at very low levels.
When these conflicted sentiment states occur, the current price (or yield for the Treasury 10-year note) is the probability-weighted average of the two scenarios. That is, market participants are weighing the probabilities of a solid recovery in 2021 with a whiff of inflation based on massive new stimulus, versus an alternative scenario of a long and sluggish recovery with no inflation pressure. Once one or the other scenario gains control of the market narrative, then the price (yield) may move quickly to reflect the controlling or realized scenario. If that happens, the current price is unlikely to prevail. The current price is merely a mid-point between the conflicting scenarios. Options strategies may be worth considering to manage this type of event risk.
One final note of caution. From an options market perspective, implied volatility calculations may be misleading. The Black-Scholes-Merton basic options pricing models assume abrupt price gaps never occur. If market participants are worried about price gapping, as they often are when event risk is present, then what is being priced in the calculated implied volatility is both the expected volatility as well as the risk of an abrupt price movement or price gap. This elevates implied volatility and puts in play time value (theta) as one has to estimate when the narrative will change.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author(s) and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
Bluford “Blu” Putnam has served as Managing Director and Chief Economist of CME Group since May 2011. With more than 35 years of experience in the financial services industry and concentrations in central banking, investment research, and portfolio management, Blu serves as CME Group’s spokesperson on global economic conditions.
View more reports from Blu Putnam, Managing Director and Chief Economist of CME Group.
Highly liquid CBOT U.S. Treasury futures are available around the clock for hedging interest-rate risk, potentially enhancing income, adjusting portfolio duration, speculating on interest rates and spread trading.