Elevator Down

2023 defied the skeptics who were forecasting a recession and bonds got crushed again. Those that played the long side in STIRs and 2 yr futures got hurt the most.  Even though the yield curve steepened, there were more losses on a risk adjusted basis from holding long positions in SOFR and 2 yr Treasury futures than in holding longs in Treasury bond futures.  It was all due to the extreme negative carry of holding leveraged long positions in STIRs when the yield curve is inverted to this extent.  It is costly betting on short end yields going lower.  But if you get the timing right, the move can be explosive, as could be seen in March when the regional banking "crisis" caused 2 year yields to drop 1.25% in less than 10 days.  

The pace of rate hikes and rate cuts are not symmetrical.  Historically, the Fed takes the stairs up when hiking rates, and the elevator down when cutting rates.  This time, with the Fed viewing the current Fed funds rate as being sufficiently restrictive, the bar to cut rates is lower than people think.  Sure, you hear higher for longer being repeated over and over again from the Fed and the parrots in the media.  But following the Fed's forward guidance has been a short cut to the poor house.  I put very little weight on the Fed's insistence that they will keep rates higher for longer until they reach their 2% inflation target.  When the economy goes south, they always put more importance on jobs than inflation.  If you get a weaker jobs market in 2024 and inflation is similar to what it is now, they will cut rates.  If they try to fight the market by not cutting, the SPX will force their hand by panicking lower.  Either way, the market will get what it wants if the jobs market is weak:  rate cuts. 

You have 85 bps of rate cuts priced into SOFR Dec 24 futures.  That is pricing in a small chance of a big drop in rates.  With the current Fed funds rate at 5.33%, even if there is no recession, a mere slowdown in growth would be sufficient to get the Fed to cut at least 50 bps next year.  The Fed hates to price in cuts into their dot plots, because they always want to sound optimistic about the economy, which justifies higher rates.  But even the dot plots have 50 bps of cuts in 2024 as the median forecast.  There is limited downside, lots of upside in SOFR futures for 2024.  In a hard landing scenario, where you have more job losses than expected, the Fed could easily cut rates down to 2.5-3% within 6 months.  That would take SOFR futures to 97.0-97.5.  They are currently trading 95.45. 

There are some that think inflation will remain sticky and keep the Fed from cutting rates until late in 2024 or not all.  Inflation won't be a big issue because inflation is only relevant when its rising strongly.  With the CPI hedonic pricing manipulation, lagged effect of housing which will reflect the much lower rent growth in 2023 in the 2024 numbers, etc., CPI inflation will likely be trending stable to lower for 2024.  Although the secular forces for higher inflation are strong, cyclically, inflation is coming down as you have a slowing economy with weak bank credit/M2 money supply growth.  The lower inflation in 2024 should not last long, as I am sure politicians will pump more stimmies in due time, probably starting in 2025. 

Next year, its going to be all about jobs.  We are getting to a point in the cycle where corporations will have to make a choice about taking high interest rate loans or working with less capital.  If they continue to borrow despite higher rates, then you won't have job losses.  But if they decide its more economical and profitable to run leaner with less capital and less labor, then they will borrow less and start cutting workers.  Interestingly, I saw a recent projection based on an employment model that points to higher unemployment rate over the next several months.  

Based on how weak the Russell 2000 has been, its fairly obvious that small corporations, and especially those that aren't even public, are having their margins squeezed by the higher cost of capital.  Companies aren't welfare institutions.  Their goal is to maximize profits, not create jobs.  If margins are getting squeezed due to higher rates, they will cut costs.  And the biggest cost is labor. 

Even with inflation data coming in hotter than expectations, Powell didn't really talk hawkish.  He was just mealy mouth and seemed like he didn't want to pound the market lower anymore.  I know its popular to say the Fed is clueless, but they are getting reports of the economy slowing.  Its not yet flowing into the economic data which is lagging, but you can see the weakness from how bad the breadth is in the market. 

Its only a matter of time before you see those job cuts start to ramp up.  Its coming.  The nonfarm payrolls number will be the biggest market moving data for 2024.  And unlike 2023, I expect the numbers to come in weaker than consensus for the next several months.  I'm sure the BLS will still be busy counting part time jobs as if they are full time jobs, and calling that jobs growth, but the info on the ground will tell a completely different story.  Labor hoarding is a thing of the past.  You don't continue to hoard labor when you are bleeding cash and interest rates are high. 

With a weakening jobs market, the move in short term rates is straight forward.  But the move in equity markets will be trickier.  I expect a bull steepening move, with short rates going down much more than long rates.  The SPX is more sensitive to long bond yields than short term rates, so a bull steepening is actually not that great for stocks.  And of course the lower consumer spending that comes with a weakening jobs market is going to hurt earnings.  So its 2 forces going against each other:  lower bond yields, which is good, but weaker earnings, which is bad.  So I don't have a strong view on how the SPX will do in 2024.  Going long SOFR and 2 yr futures looks like a much cleaner bet on a weaker economy and an imminent Fed cutting cycle than shorting the SPX.

Last thing to remember is that the Fed is political.  In particular, Powell's job is on the line based on the result of the 2024 election.  It appears Trump is going to be the favorite to win, as a weakening economy and preliminary polls showing him leading Biden in the battleground states give him the edge.  Powell will be motivated to stimulate the economy as much as possible ahead of the 2024 election, trying to keep the stock market as high as possible to help Biden.  If Biden wins, Powell gets re-nominated.  If Trump wins, Powell will be fired.  Powell is no dummy.  He knows this.  The weakening jobs market and stable to lower CPI will give him cover to make aggressive rate cuts in 2024. 

Bottom line, the dominoes are lining up for a big reversal of the rate hiking cycle in 2024. Higher for longer has been repeated for so long by the media and Fed officials, it's become a mantra.  If you repeat a lie for long enough, eventually people believe it.  It means that people aren't positioned for a big move lower in short term rates.  You don't benefit from a big move lower if you are in money market funds or T-bills.  The most effective way to make money in this situation is to make a leveraged long bet in the STIRs market.  With the heavy negative carry in holding leveraged long positions in STIR products, you have to wait for the right timing to put on the trade.  I don't think there is much time left, maybe till the end of this year, to be able to put on longs in STIRs at good levels.  A couple of bad NFP reports should ignite the short end of the yield curve.  With CTAs loaded up short in short term interest rates, and the Street still believing in higher for longer, the setup is ripe.  

SPX is grinding higher despite the bond market's weakness since the horrible 30 year bond auction.  Still not seeing the put/call ratios go down much even with the steady move higher.  From watching CNBC, there is still a wall of worry out there, which is only slowly being climbed.  The Moody's ratings warning on US sovereign debt was only good for a few hours of weakness, and the beach ball bounced up again.  The price action is strong.  The leaders, the Mag 7 are performing.  Monthly opex is this Friday.  The forces pushing this market higher should remain strong until later in the week.  Staying long with a moderate long position.