Sun Rises in the Bond Market

The positive correlation between stocks and bonds is weakening as the focus shifts from inflation to economic weakness.  The CPI report in November was the game changer.  It gave bond investors the green light to start buying as the fear of an inflationary price spiral and a possible UK like bond vigilante led squeeze higher in yields was put off the table.  As most bond fund managers have been afraid to add duration ahead of this freight train bear market, there was a lot of pent up demand that was building as 10 year yields broke the 2022 highs of 3.50% and squeezed mercilessly higher into late October, only to be saved by a nervous Fed using their loudspeaker, Nick Timiraos of the WSJ to calm down the market.  The day that Timiraos came to the rescue on October 21 was the top in 10 year yields at 4.33%.  

Since the CPI release with the softer than expected inflation print, bond investors have come out of their bunkers and looked at the charred landscape as 10 yr yields have gone from 1.51% at the start of 2022 to the mid 3s.  People forget in times of distress what they are buying and selling.  A 10 year Treasury note is pricing in the average of the Fed funds rate over the next 10 years + term premium.  It is a world where developed world population growth is approximately zero, and productivity is also around zero (maybe negative given the work from home trends, lack of meaningful technological advances, and increasing labor power = lazier workers).  Nominal GDP growth will be driven by inflation, not economic growth.  Expect a return to secular stagnation until the next big stimulus package (2025 story?).  2020-2021 was an anomaly.  You had a convenient excuse for politicians to go full bore populist and spew out tons of fiscal stimulus for individuals, state and local governments, and corporations.  

That is something that will happen again, but the stars have to align to get that kind of scale of coordinated, global fiscal pump priming.  The right mix of Republican and Democrat control of White House and Congress, either total control for one party or a Republican president.  Republicans will obstruct fiscal stimulus if there is a Democrat president in power, but not if its a Republican president.  And Democrats always believe in moar fiscal stimulus, no matter who the president is.  So in most cases, a Republican president leads to more fiscal stimulus than a Democrat president because its not common for Democrats to control both the White House and both Houses.  

Back to the bond market.  Its has been in a 26 month downtrend from August 2020 before it finally bottomed in October.  That is a LONG downtrend.  You have flushed out a lot of weak hands during that process, while offering much more attractive yields for long term investors.  Yields that are high enough where bonds can now provide a risk off hedge to equities once the rate hike cycle is done, which looks to be less than 3 months away.  Due to my pessimistic view on global growth, and even US growth, I lean towards the bullish side on bonds in most situations.  I definitely underestimated the inflationary effects of all that Covid stimulus but its looking like most of that has worked its way through the system.  With prices already having gone up a lot in 2021 and 2022, the base effects for inflation prints will favor disinflationary views over those who think inflation remains sticky in 2023.  The M2 money supply has been dropping steadily in 2022, which is rare to see.  I don't see a wage price spiral happening when the supply of money is no longer increasing and when the demand for workers is dropping as the economy gets weaker.  When the economy weakens, workers have to worry about potentially getting fired, which reduces their wage bargain power, and you have fewer workers switching firms, another source of wage growth.  

Lately, the yield curve has gone into a super inversion.  2-10s are trading -83 bps.  Look at the move in 1-10s, historically extreme:

Take a look at when the 1-10s spread went into negative territory, a sign that the Fed is overtightening and about to push the economy into a recession.  1989, 2000, 2007,2019.  They all resulted in sharp curve steepenings as the Fed aggressively cut rates in all 4 cases.  I expect a similar outcome this time around.  In fact, with the curve that much more inverted now, the curve steepening move will be vicious.  I am still seeing most fixed income analysts call for the Fed to keep rates high and not cut in 2023.  So betting on aggressive Fed rate cuts for the 2nd half of 2023 is both an out of consensus view, and also not priced into the SOFR futures curve as Dec 2023 is trading at 4.38%, which is only 52 bps lower than the 4.90% terminal rate pricing in Mar/June 2023.  The risk reward is quite good in the short end of the curve at current levels, although timing it will be important.  The roll up in yields is extreme at the short end of the curve, so the negative carry for being long 2s and short 10s is almost 40 bps/year.  That is a big chunk to pay out for a curve bet, but it should pay off big when the Fed enters a rate cutting cycle.

From the daily headlines, CNBC, and Bloomberg, slowly more are becoming aligned to the recession view, and that's part of the reason you are seeing the big rout in crude oil even as US inventories keep going lower and China loosens it Covid policies.  There has been heavy liquidation of long positions in Brent and WTI futures over the past couple of weeks.  With the curve going from backwardation to slight contango, systematic commodity traders are reducing longs and adding shorts. 

In trading, sometimes the market just induces you to take a position which you never thought about taking so soon.  The big drop in crude oil this week is piquing my interest.  Even with the short term cyclical headwinds and demand weakness that is sure to come down the pike, at a certain price, the risk reward turns positive for buyers.  We are probably already at that point, but I will wait for an even better level.  This is a seasonally weak time of year for crude oil, and there are still residual bagholders who still cling on to hopes of $100, $150, $200 oil.  There are plenty of barrel counters who are besides themselves trying to figure out why crude keeps going lower as crude inventory levels go lower, amidst China reopening hopes.  That has kept me away from the long side.  But I'm noticing that some of the permabulls are softening their bullish rhetoric.  Oil stocks have massively outperformed the commodity in 2022, so if I play for a long, it would be in oil itself, not oil stocks.  Something that is on the radar.  

Closed out part of the NDX short yesterday in the premarket, and will look to close out the rest today.  Finally got that big spike in put/call ratio to 1.17 yesterday, and noticed that the fear was building up watching CNBC.  After today, probably will not play the short side in NDX or SPX until after Christmas, as I see little edge shorting during a seasonally strong period of the year, and ahead of CPI and FOMC, which probably will result in a relief rally.  Even though I think SPX will go up next week after the big events are behind us, I will not play the long side.  The levels just aren't attractive and there is rug pull risk in the unlikely case that Powell puts back on his hawk costume or you get a hot CPI.  I will let others fight those battles.  Its still a swing trader's market in SPX.  If we get a big rally after the CPI and FOMC, then we can talk about taking longer term short positions later in the month.  Especially in tech.  Until then, letting the market come to my buy or sell levels to put on positions.  They need to induce me to take a position by getting to an extreme, because there is nothing that's really attractive at current levels.