Long Bonds vs Short Stocks

The 2 most common ways to express a bearish view on the economy is to be long government bonds and to short stocks.  Last year, one of those worked very well, the other one was a disaster.  Investors fight the last war.  They have been clobbered trying to buy dips in Treasuries for over 2 years, as you can see from the TLT chart below.  

Despite the big drop in the SPX in 2022, the real economy was quite resilient, still riding the inflationary wave from the bazooka Covid stimulus.  That was a disaster for Treasuries, as high inflation, high nominal GDP growth, and a Fed starting a power hiking cycle was the perfect storm.  

But its a different story now.  Inflation has peaked, even though price levels are still rising.  People sometimes forget that inflation is a rate of change measurement.  Even as prices go higher, as long as they are going higher at a slower rate, then inflation goes down.  That's what's happening now.  And due to last year's blow off top in crude oil, you have some abnormally large base effects coming through for the next few months.  This will bring year over year CPI down dramatically in the coming months.  People talk about inflation being sticky, but this is what the CPI readings will be with the corresponding month on month inflation numbers.  With a month on month inflation number at 0.3%, which is near consensus, the CPI will be down to 2.75% by June. 

I am hearing very few people talk about this.  People are still more worried about sticky inflation, despite WTI trading around 80, lower than almost all of 2022.  A CPI below 3%, as jobs numbers start to shrink, tighter credit in the economy due to less bank lending,  and more cash hoarding into MMFs: near ideal conditions for bonds.  As fuel for the fire, hedge funds and CTAs are still positioned very short despite the big rally since SIVB went bust.  The speculator net position in 5 yr Treasuries is the shortest since 2018. 

 

Also, you had huge outflows out of bond funds last year, the most since 2010, which is atypical as the age bracket with the most money, the boomers, will be adding to their bond weighting and reducing their equity weighting over time.  You are starting to get some reversal in that trend in 2023, but still a long ways to go to undo last year's massive outflows. 

There has been a sea change in household asset allocations since the start of the ZIRP and QE era in 2008.  Households are now heavily allocated in equities (35.6%) and have very little fixed income exposure (5.8%).  

Household Allocation to Equities as Percentage of Financial Assets

Household Allocation to Bonds as Percentage of Financial Assets

Just as the yields offered by bonds is the most compelling since 2007, you are seeing most investors heavily overweight stocks and underweight bonds in their portfolio.  

From a big picture standpoint, both being long bonds or short stocks for the next 6 months look like a good risk/reward trade.  But I give the edge to being long bonds because of the underweight positioning of most investors in fixed income, and the popularity of cash, which will get deployed sooner or later.  I expect most of that cash to flow towards bonds as the economy continues to weaken in 2023.  Also, being long bonds is a less crowded trade due to still lingering inflation fears than being short equities.  When most of CNBC Fast Money are bearish, as they have been for the past few weeks, I am reluctant to get aggressively short SPX. 

On the recent action in the stock and bond market:  you are seeing the beginning of a divergence in price action with stocks and bonds, a subtle return of the negative correlation.  It appears that bad news is acting as a positive for bonds, but no longer a positive for stocks.  This makes sense because the Fed is basically done with their rate hiking cycle, and any good news will not encourage the Fed to hike beyond May.  But bad news won't encourage them to cut either right away, thus the divergent path of stocks and bonds.  

I've noticed quite a few who are puzzled by the resilience of stocks despite signs of a weakening economy and a likely hike in May (currently 70% odds from Fed funds futures).  A lot of it is due to a much lower realized volatility in the indices, making vol control funds add equity exposure.  Also you have the seasonally strong April time period which is usually good for stocks.  And you have hedge funds that are still at low net equity exposure, which keeps potential bids in the market as hedge funds are more likely to add exposure than decrease it.  And lastly, there is the Fed's pivot card which still hasn't been pulled out, but is getting closer and closer.  What I mean by pivot is the Fed saying they will be pausing, which is akin to opening the door to future cuts, because naturally at these high rates, with the economy slowing and credit tightening, its a matter of when, not if they cut.  That will be the equity rally to fade.