From Altered Beast to Human

2023 is a much tamer animal than 2022.  If you want to make an analogy, 2022 was a wolf in the wild.  2023 is a kid in the backyard.  We got a throwback from 2022:  Hawk Powell.  If you heard that in 2022, it would have been absolute chaos.  This time, not so much.  Its not doing much damage to the long bond, which hardly moved down on the threat of a faster pace of rate hikes if data comes in hot this month.  But it crushed the short end of the yield curve, and now we have 2-10s curve inversion of 100 bps.  Something unthinkable a year ago.  

The power flattening of the curve, is telling you:  1) these high rates are not sustainable for very long and will cause economic weakness 2) there is a ton of liquidity in the bond market, as even QT and large Treasury issuance is unable to cause much of a selloff in the long end.  The relative tightness of credit spreads is also a signal of abundant liquidity.  The Fed's QT program is a joke.  MBS is hardly rolling off, as no one will re-fi in this environment, so the Fed is only reducing Treasuries in its balance sheet, and that is capped at $60B/month.  Don't forget back in the peak of the Covid money spew in spring 2020, the Fed were buying $75B/day of Treasuries.  Adding liquidity with a firehose, and taking it out with a straw.  Typical.  The Fed's balance sheet is still sky high, and bloated with low yielding coupon debt.  The Fed has essentially eaten the huge losses in MBS that private market would have had to bear in 2022.  This time, with the Fed's thumb all over the MBS market, there will be no mortgage crisis.  Its just likely to just be a classic slow bleed economic slowdown. 

If we just had normal liquidity conditions, it would be a toxic environment for stocks.  But we don't have normal liquidity conditions.  The budget deficit is high, the Fed balance sheet is still huge, and all that money pumped out in 2020 and 2021 is floating around in the financial markets, looking for a home.  Everything the government has done over the past several years has been stimulative:  tax cuts for corporations and middle/lower class in 2017, $5 trillion in Covid stimulus in 2020 and 2021, big fiscal budget increases the last 3 years, Inflation Reduction Act, student debt forgiveness, and most recently COLA inflation adjustments to Social Security, boosting handouts to the elderly.  No wonder the budget deficit hit 6% of GDP last year, even with huge capital gains and an overheating economy.  In the past, those budget deficits during boom times would be between 0-2% of GDP.  That's 5% more spending and less taxes which goes straight from the government's printing press to the pocketbooks of the masses.  If the government spending continues at this pace, those are the foundations of a sustained inflationary environment.  While it is very unlikely you will get much one-off spending bills in the next 2 years due to gridlock in Washington, it is likely you will get more pork stimulus starting from 2025 with a new President and/or a Democrat majority Congress.  

So as a short seller even though you have the Fed on your side (for a few more months), you are still fighting some strong forces on the other side, which is the ample accumulated liquidity.  In 2022, the vicious bond bear market and the rate shock was sufficient for the bears to overcome the big liquidity advantage that the bulls have.  This year, its a more even battle.  

Another reason for the resilience of the stock market:  volatility.  Volatility is down in both the stock and bond market.  Credit spreads are tighter than the 2nd half of 2022.  The uncertainty on the rate hike path for the Fed, despite yesterday's hawk Powell performance, is lowered from what you saw in 2022.  As a result, you get milder selloffs on bad news and the lowered volatility encourages dip buying.  When volatility is high, as it was in 2022, the demand for riskier assets such as equities and long duration bonds goes down.  But as the volatility in both the stock and bond market has died down in 2023, that suppressed demand for duration has come back even though the earnings fundamentals for stocks or long term inflation expectations for bonds haven't improved.  

What am I seeing in the COT reports and sell side CTA trackers is CTAs being much less short than they were in the fall of 2022.  Vol control funds and risk parity are steadily adding back long exposure to stocks, and to a lesser extent bonds, as both the VIX and MOVE index are lower than 2nd half 2022 levels.  Over the next few weeks, the vol control and risk parity funds should be done adding to their risk exposure.  At that point, you get a better set up on the short side as seasonality starts to turn worse with  tax refund season behind us and with a continued drawdown on excess savings from US consumers.  Its not going to be a sudden crisis situation like 2008, but more of a drawn out drip lower as the fiscal stimulus from 2020 and 2021 begin to wear off and credit conditions tightening with the higher rates.  

It is easy to forget about the Covid stimulus when all we hear about is the Fed and rising interest rates but the aftereffects are still reverberating.  $5 trillion dollar dropped from a helicopter into the economy distorts reality.  We are still not back to normal, no matter how fast the Fed wants to get inflation down.  One has to question why the Fed is not increasing the rolloff of the balance sheet, as the $60B/month of Treasuries has been woefully inadequate.  I guess Powell doesn't want to hurt too many of his friends in private equity by doing a power QT of say, $200B/month of Treasuries.  It can actually be argued that raising short term interest rates is just a stimulus for the rich holding a lot of cash, and just punishing those who have to borrow money.  If the Fed actually wanted to tighten financial conditions and reduce wealth inequality, he should stop hiking rates and instead increase the pace of QT with outright sales of long end Treasuries.  Of course, that will not happen, because there are no out of the box thinkers at the Fed and they still want to coddle the bond market while trying to kill consumer demand.  

Back to the markets.  We reached a short term bottom last Thursday, earlier than I expected, as this year's markets are not selling off that extra few days that really makes the longs question themselves, like what happened in 2022.  Short term traders need to recalibrate themselves to expect less on the downside, and expect more time spent at the top.  Until you get a noticeable shift down in the economy that leads to more layoffs and less sanguine consumers, you will continue with this low volatility, low energy market.  Compared to the 2013 to 2019 markets, this is not boring.  But compared to 2022, it is. 

I've noticed that the new mantra from the stock "experts" on TV is:  cash is not trash.  It is unusual and rare for the stock "experts" to tout cash as a good alternative. Considering their tendency to be late to a trend, it probably means that cash will be underperforming a stock and bond portfolio in the coming months.  If you see economic data cool off like the leading indicators are forecasting, that will provide support for the bond market which will provide support for the stock market, as the market will price in a less hawkish Fed and a return of the goldilocks/soft landing thesis.  Under that scenario, I could picture the 10 year going back down towards the bottom of its YTD range, to 3.50%, and the SPX to return to the top of its range, towards 4200.  

I have used the weakness yesterday to reduce my single stock shorts and add some bond exposure.  I see downside in fixed income as being limited, and thus downside in stocks as well.  The strength of the long end of the yield curve is a sign of underlying demand for bonds that won't go away easily.  The demand for duration is slowly coming back as the trauma from 2022 is further in the rear view mirror.  Those planning to decrease bond portfolio duration is at a 2 year low at 13%. 

With the overflowing liquidity out there, and at current price levels, buying bonds is a superior way of expressing a view of a weaker economy later this year than shorting the equity index.  Don't get caught up in 2022 mode of trading and investing.  This year has a different character to it.  It is tamer.  Those that can adjust to this new reality will outperform those that are still stuck on the 2022 playbook of shorting stocks and bonds.