More Bond Pain Ahead

Bonds are the focus of attention in financial markets.  You have the geopolitical monkeys who get excited whenever the media goes overboard reporting on fighting overseas, but they can only move markets for a couple of days before prices mean revert.  So geopolitics doesn’t matter.  Bonds are where the action is. 

Here’s my theory on why bonds are getting crushed.  At the start of the year, the vast majority was expecting a recession sometime in 2023 due to:

1.  Huge move higher in yields in 2022 and a hawkish Fed

2.  Bullwhip effect leading to too much inventory, leading to a big slowdown in the manufacturing and goods economy

3.  Drawdown of Covid era excess savings leading to reduced consumption

But the US economy in 2023 has been well sheltered by low fixed rate mortgages refinanced in 2020 and 2021, low term rate bonds and loans issued in 2020 and 2021, and implementation of Bidenomics fiscal pork bills like CHIPs, IRA, and infrastructure.  Add in the COLA adjustments higher for Social Security checks to the elderly and you had a huge blowout in the budget which kept the economy buoyant in the face of higher rates.  

So we never got the recession and stocks surged higher, which was responsible for the 10 year yield move from 3.60% to 4.20%.  How about the move from 4.20% to 5% since the start of September?  We didn’t have any significant economic data and the Fed has actually become less hawkish, showing their reluctance to hike further.  Many people point to supply, but the supply of coupon bonds has been large and steady throughout the year, so there's not much change there.  It appears that the move comes down to simply having price sensitive buyers up to their eyeballs in bonds, so the marginal buyer could only be found at lower prices.  The supply/demand mismatch has been present since the Fed started QT.  There has been a continuous deluge of USTs being issued since 2020, due to the monster budget deficits.  This was masked by a bazooka QE in 2020 and 2021. And then in 2022 and first half of 2023, by temporary duration demand from those thinking recession in 2023.  But that marginal bid went away after it became apparent that the US economy was much stronger than forecast.   What you are seeing now is a Treasury market normalizing to a non-recession US economy with rate cuts nowhere in sight.

The yield curve was absurdly inverted as recently as August.  You had Fed funds at 5.33%, 2 year at 5%, and the 10 year at 4%.  The yield curve was pricing in an imminent rate cutting cycle, and if that rate cutting cycle doesn’t come soon, the yield curve has to steepen to reflect the lack of cuts.  That’s what happened.  During the bear steepening, you have seen a parade of investment managers and analysts talk about how cheap bonds are, how attractive they are, etc.  There’s been no real fear on TV.  The only fear you see is the fear of missing out on a "generational" buying opportunity in bonds.   

Despite the huge selloff in bonds, active money in the JP Morgan US Treasuries survey was most bearish at the start of the year, and was the most bullish earlier this month.  That's not what you normally see at bottoms for financial assets.   And you have the options punters who rarely make money coming out and buying huge amounts of TLT calls, making leveraged bets on a quick recovery in long bonds.  You see much less volume in TLT puts, even though the trend is firmly lower, and puts are the ones that have been paying.  So from a positioning standpoint, it still looks like more blood needs to be shed before you can get a tradable bottom in bonds. 

Fundamentally, in order to get a big move higher in bonds, you need an environment where the Fed is likely to start cutting.   Its not going to be inflation sliding lower, because that's going to take too long.  You need the unemployment rate to go up.  The labor market holds the key to the future of Fed policy, as its much more likely that the labor market cracks before you get a CPI low enough to induce the Fed to cut quickly.  Fed only cuts quickly when there are job losses, not when there are low CPI prints.  I doubt you see a credit event come to rescue underwater bond holders, like some well known, but usually wrong market gurus are warning about.  

 

Higher rates work more like low kicks than high kicks to the side of the head.  Credit events are high kicks to the side of the temple.  Events that most people don't see coming.  If you saw the head kick coming, you would duck and avoid it.  But if it hits you, it means that you didn't see it coming until it was too late.  Lagged effects of monetary tightening are like low kicks to the calf.  Big difference.  The low kicks take time to accrue damage and the result isn’t devastating like being knocked out.  What’s most likely to happen in this cycle is corporations will slowly reduce labor to match the reduced capital rather than borrow at high rates that don’t provide a positive return on investment.  Only when the labor market weakens enough will you grab Powell’s attention.  I don't see that as being imminent, as the US is quite well buffered against rate hikes, and the budget deficit, will remain large, although most likely to decline somewhat. 

 

Bottom line, we all underestimated the power of fiscal stimulus in 2023 and still underestimate it now.  But without a doubt, 2024 will have less fiscal support for the economy than this year due to higher capital gains (more tax revenues from higher SPX, NDX), resumption of student loan payments, less COLA boost for Social Security due to lower CPI, and lower spending at the state and local level due to drawdown of  excess Covid funds.  Below are projections for 2024 state spending in a few states.  This will work to reduce demand at the margin. 

 

While bonds have sold off a lot, I don't view them as a bargain, like some some eager speculators.  I am hesitant to buy this dip (more like a trench) in bonds.  The supply/demand equation is unfavorable, and expectations are quite low for the economy in 2024, so its not going to be easy to surprise to the downside.  This is why I am not bearish on SPX, because of those low expectations.  Its not everyone on recession alert like end of 2022, but you don't see much optimism about the economy in first half of 2024 from those on CNBC or Bloomberg.  The most likely scenario for the next few months is the US economy gradually slowing down, but not more than the low expectations people have.  That should keep stocks in a range, around SPX 4200 to 4500.  During that time, I expect bonds to settle down, but I don't expect a big move lower in yields, probably lingering somewhere between 10yr 4.6%-5.2%.  Unless the labor market gets much weaker, you will not get that big rally in USTs.  That's going to take a few months, because the labor market is always lagging, and the US economy is just not weak enough yet for mass job cuts.  

 

Missed the graceful exit on my SPX and NDX longs last week.  Sold a bit on Friday to reduce risk, and reduced a bit more on Tuesday, as the price action is quite weak, and I want to have some dry powder just in case we get a bond panic as 10 year yields decisively break above 5% and SPX decisively breaks 4200.  If that happens, I will buy that dip.  This stock market is trading much weaker than expected, so my confidence level on a strong rally has gone down.  Its very much possible we just get a underwhelming dead cat bounce towards 4300, but that's not the base case.  Base case is a move towards 4400-4450 by mid November.  Looking like you won't see any strong uptrends or strong downtrends in stocks for the time being.  Looking more and more like a range bound market for the next several months as the earnings momentum will not be strong enough to get stocks meaningfully higher, but at the same time, expectations seem too low and I don't think the economy in 1st half of 2024 will be as weak as many are forecasting.    Plus many are hiding out in the comfort of cash so there is a lot of dry powder waiting to be deployed in stocks out there.  So that will keep downside contained.