Collision Course

The dead horse is coming back to life.  The bond market is no longer getting bullied by hawkish Fed rhetoric.  In fact, its starting to flat out ignore any of the hawks who insist on using forward guidance to price in higher rates further out on the curve.  2-5s are inverted by 50 bps.  2-10s inverted by 65 bps.  This is not a long term sustainable situation.  It is amazing to see this level of curve inversion when you still have multiple hikes priced in the next few months.  Especially as you have been getting steady outflows from bond funds as well as the draining of liquidity from QT.  And the bond market is defiantly replying "balderdash" to Fed hawkishness by pricing in several rate cuts starting in the 2nd half of 2023 and even more in 2024. 

Its a battle now.  Fixed income traders vs the Fed.  They are on a collision course, with one side saying the Fed will cut in 2023 and the Fed denying it and talking of a higher for longer plateau.  I am siding with the fixed income guys.  They aren't perfect, but they have a much better track record of forecasting future rate moves than the Fed.  And the economic leading indicators are flashing red.  

Just doing basic macro 101 analysis will tell you that a steep inversion in the yield curve, especially towards the front end, is a warning sign of a coming recession.  Add to all the demand that was used up to buy "stuff" in 2020 and 2021 and you have a consumer that is no longer in a rush to buy goods.  As for services, that post Covid pentup demand was released in 2022, and will go back to normal levels in 2023 and beyond.  

The excess savings are steadily being used up, as inflation and the negative wealth effect take their toll on the consumer.  With gridlock guaranteed after the Republicans taking the majority in the House, there will be no big stimulus packages coming down the pike.  Without fiscal stimmy, the secular stagnation theme will come back with a vengeance.  After all the talk about free spending governments, with gridlock the next 2 years, you are likely going back to monetary policy being the only game in town.  

And when the Fed has to try to make up for weak growth with loose monetary policy, they usually overdo it, because they can't help themselves.  Sure, they say they won't backstop financial markets, but its one thing to say it now, before the economy turns sour.  But when things get ugly, they've always come to the rescue.  Its in their mandate.  Its what they do.  

The more the Fed tries to fight the bond market with hawkishness, and more rate hikes, the more quickly they bring on the pain point for the economy, forcing a quick turnaround from hikes to cuts.  The rate hike path will be more like the Matterhorn than a big plateau.  

We have been pulling back after that euphoric pop on a weaker PPI number on Tuesday, as nervous shorts and underweight longs were afraid of another CPI like day. I took advantage of the strength to put on NDX shorts.  If we get a further pullback this week, I will cover to re-deploy shorts on the next rally.  The strength in the bond market and dollar weakness should prevent any big rug pulls for the time being, so I won't get greedy looking for a big down move.  After a couple more weeks of bulls coming on board, by early December, that should be the time to put on a bigger short and with lower price targets.  Staying nimble for now, no need to dig in the trenches for a long war.  Just quick strikes on the short side until I see more of a saturation of bulls.