5 Year Making Moves

Bonds will soon be the new "hot" thing.  You can feel the strength underneath, the buyers waiting for a chance to get in.  Selloffs don't last even with a pumping stock market.  It was as if the whole fixed income community was waiting for the result of the ECB meeting, the first hike for the ECB since 2008, to buy.  Whether it was 25 bps or 50 bps, they were going to buy after the event had passed no matter what.  

Sure, you had higher jobless claims and a weaker Philly Fed report, but those aren't really important data points.  Bonds don't fear economic data anymore, now that gas/diesel prices are much lower than last month.  Bonds only fear stubborn central banks looking to continue to raise rates and QT. 

The collateral effect of bonds suddenly exploding up is higher stock prices.  All things equal, higher bond prices give comfort to stock investors as their bond holdings gives them a working hedge.  But there is a caveat.  The Fed needs to make a dovish pivot soon to keep the party going, otherwise stocks will go down as bonds are rallying.  Since 10 yr yields are now around 2.80%, if Powell keeps with the hawkish talk,  the curve really gets inverted and that will start breaking things.

The stock market grace period is almost over before it has a temper tantrum.  A 2 handle on Fed funds is a psychological meaningful.  That is actually a somewhat decent return on cash.  As economic data further deteriorates and signs of a weak economy become more pervasive, stocks and credit markets will have to go down meaningfully or Powell will stay on automatic pilot towards 3.50% and maybe higher.  That would spell eventual disaster for the stock market.  Counterintuitively, the quicker the stock market panics and credit spreads blow out, the less pain Powell will have to inflict on the economy. 

The market that I trust the most to reveal the truth about the economy is the commodity market.  More than the bond or stock market.  In a steady state supply situation that you have in copper, demand is setting prices.  

Copper is telling you manufacturing/construction demand is dropping fast.  More so than oil, copper gives you a better picture on capital expenditures and investment.  Oil is also weak recently, despite tight supply.  Just reinforcing the weak economy message.  Those celebrating lower oil prices need to realize that oil prices are going down because of lower demand and a weaker economy, which are negatives for the stock market, especially when the Fed is still taking away liquidity.  Sure oil going down will help to lower the CPI reading, but the nature of the owner equivalent rents calculation will keep those prices rising for a while.  

From the current politicized climate around inflation, Powell has gotten the message.  Inflation is the priority by a mile, and with employment numbers the most lagging of indicators, it won't show how bad the economy is for at least several more months, which gives Powell cover to stay on automatic pilot to 3.50%, unless the stock and credit markets start going down hard.  A gentle down move won't do it, it has to be enough to grab his attention, perhaps SPX down to 3300 or so, with credit spreads trading much wider.  

So the question is will the stock market just let Powell get to 3.50% without telling him to stop?  I doubt it.  3.5% Fed funds is not palatable with the current valuations in the stock market.  Not with the current economic weakness.  Remember in December 2018 when the Fed raised 25 bps to 2.5% and the market went into a rage and got him to make a dovish pivot? The economy is much worse now.  Much more wealth destruction and much higher inflation.  He's going to raise 75 bps to 2.5% next week and it feels like a relief after getting such a big CPI number.  The market is way too complacent on the rate hikes.  Just like in 2018 when the market was going up as Powell was raising 25 bps every quarter but then he reached the market's uncle point and the stock market went crazy and got the job done, as Powell pivoted a couple weeks later.   

 

My expectation is that the stock market is closing in on the temper tantrum point of no return, as you are starting to see extreme bull steepening, as the 5 year yields went down 30 bps over the past 24 hours!  While the 30 year only went down 15 bps during that time.  The 5 year is the most economically sensitive part of the curve, and is starting to raise its voice to the markets, telling you the economy is noticeably weakening.  This is the same thing you saw in November 2018, when the bull steepening started in earnest, led by the 5 year. 

Unlike 2018, the Fed is dealing with an inflation problem, and will have to see much more damage than he saw in December 2018 to make a dovish pivot.  The politics around inflation are totally different in 2022.  He can't look weak on inflation, so its got to get really bad before he signals a change.

Decided to go for the home run move by short NDX instead of going long Treasuries and paying the price.  Long bonds is always a safer play than shorting the stock indexes in a rapidly weakening economy.  At first, the stock market likes to see bond yields going lower, lowering the discount rate, while ignoring the real signal of future economic weakness.  I'm already gone down one fork in the road, and at these levels, the payoff on an NDX or SPX short are much greater than a long Treasuries position.  

With the stock market worried about weaker earnings guidance, there could be a bit more of a relief rally next week after the majority of tech earnings get announced, as more shorts cover and more fast money longs look to play a bear market rally, but that's probably the final hurrah before things get real in August and September.