Bonds Crying for Help

The bond market is getting destroyed.  The US Treasury market is screaming a cry for help.  But politicians, Treasury, and the Fed are ignoring its cries.  The bond market is begging for Yellen to come out to say they will be doing Treasury buybacks or will issue more T-bills and less duration.  Or Powell to come out and say that QT would likely be stopped when the Fed cuts.  Or for Congress and the White House agree to spending cuts to lower the budget deficit.  Those are unlikely to happen.  So the bond market is on its own.  The US government brought this upon itself.  You only get a selloff of this length and magnitude in the biggest, most liquid bond market in the world when there is a huge fundamental change.  That change has come gradually and then suddenly, just like how people go bankrupt.  

First the gradually part.  It didn't start with the 2008 recession.  Contrary to what many believe, Obama was not a big spender while he was in office.  In the first 2 years when he had both Houses of Congress under Democrat control, he didn't do a Biden style big fiscal stimulus, even though the economy was in a deep recession.  He did small, piecemeal fiscal packages that hardly moved the needle.  The big budget deficits from 2008 to 2010 were mainly due to tax revenues tanking because of huge losses in jobs and capital, not lots of spending or tax cuts.  For the rest of Obama's tenure from 2011 to 2016, the Republicans controlled the House, and they pushed for spending freezes while the economy was in a low growth, low inflation environment.  That was a huge boon for the bond market, as the Fed was stuck at zero because fiscal stimulus was not coming, and the organic growth rate was just too low.  

Then Trump gets elected, and you get huge tax cuts as well as spending increases, increasing the budget deficit up to trillion dollar territory during expansionary times.  That was the first sign of trouble for the bond market, and you did get the Fed to actually start raising rates again because inflation was creeping higher, and the economy was slowly heating up.  This was the beginning of the end for the bond bull market, as the wave of populist fiscal policies gained traction in Washington D.C., and politicians realized that voters like tax cuts, they liked stimmies, and they didn't really care about the national debt or the budget deficit.  You had MMTers urging on more fiscal spending, with inflation just a mere afterthought.  

All of this created a huge tinderbox that was just waiting to ignite with a flick of a lighter.  That was Covid in 2020.  You don't get the huge fiscal response if you have politicians worried about the budget deficit and spending too much money.  And politicians like to follow what is popular, and they realized that handing out cash for nothing was extremely popular.  And because of the low inflation decade from 2011 to 2020, they felt like inflation wouldn't flare up even if they spent trillions of dollars!  And even if they thought inflation would go up, it would happen a few years later, so it didn't really matter to them.  So you had the perfect recipe for reckless fiscal policy in 2020.  And because investors had been so used to a long bond bull market, and with rates getting so low, bond investors felt invincible.  Ignoring the negative consequences of such outrageous spending.  

So Trump and Mnunchin in 2020, with the firm approval of Pelosi, went to give out trillions in stimmies to individuals and corporations for doing nothing, or just keeping employees on payroll, for way longer than necessary.  Powell got in on the action and printed gobs of money to monetize the debt so rates would be super low, especially mortgage rates, while all this happened.  It was a huge transfer of money from the public sector to the private sector.  The repercussions of all that stimulus still reverberate today.  

Then Biden just pours gasoline on the bonfire while having great luck by having the House and Senate under Democrat control, by the skin of his teeth.  Enabling him to pass trillions more in pork spending packages in the form of infrastructure, CHIPs, and IRA bills.  Inflation was already starting to rage, this just added to it.  Bidenomics = Inflationomics.   He is the most inflationary president in US history.  You can't totally blame him.  He is a politician.  He does what is popular.  And spending money is popular in America.  Because it reduces unemployment and gives people more cash.  And the inflationary consequences come later.  It embodies the American mindset.  Buy now.  Pay Later. 

These Biden spending bills are the main reason that the US economy is outperforming the European and Asian economies in 2023.  American exceptionalism is massive, shameless pork spending and huge budget deficits, fully utilizing its reserve currency status to prime the pump.  It is not sustainable in the long term.  Reserve currency status is hard to obtain, but once obtained, it is easy to hold on to.  People are stubborn and hold on to long held beliefs until the evidence becomes overwhelming to make them change their mind.  The US government is doing everything in its power to abuse its reserve currency status by running multi trillion dollar budget deficits in expansionary times, having a huge Fed balance sheet that is excruciatingly slow to be reduced by a peashooter QT policy.  Take a look at the fiscal deficits as % of GDP.  It never was so low in an expansion as you are seeing in 2021-2023.  Budget deficit of 8% of GDP with unemployment at 4% is ridiculously expansionary policy.  That is why inflation isn't coming down faster and why the recession isn't coming. 

 

The US Treasury market is now starting to convulse from all the mistakes that politicians made for the last several years.  You can't blame Powell for this mess, although he was huge enabler in 2020 and 2021 with all that QE.  Its Argentine fiscal policy that is causing the huge rout in the most important bond market in the world.  There are only two ways this gets resolved:  1) Treasuries keep going lower until they find fair value for the current fiscal environment of reckless spending and tax cuts with no regard for budget deficits.  2) The US government starts to control its spending and causes a recession, which brings a bid back to USTs. 

It is out of the Fed's hands now.  They are not the bus driver, as many think.  They are bus riders.  The bus drivers are the President and Congress.  They control the future of interest rates, not Powell.  The long term future for US Treasuries and the US dollar look bleak.  Yes, even the almighty dollar.  The last time the US ran such big budget deficits during an expansion was in the early to mid 1980s under Reagan.  The US dollar kept going up until it didn't.  Here is what happened to the US dollar in the 1980s. 

I expect a similar situation this time around, with the dollar remaining strong until the trend reverses violently in the other direction as a massive US budget deficit causes the supply of US dollars to overwhelm demand.  Also, the US dollar is fundamentally overvalued based on PPP to Europe and Japan, the 2 biggest weightings in the US dollar index. 

The SPX is following the seasonal patterns to near perfection.  You got the initial weakness in August, followed by strength at the end of that month.  And then September follows through with its reputation of being the weakest month of the year, with the weakness back end loaded into the second half of the month.  This is not voodoo.  Seasonal patterns happen for a reason.  Post quarterly options expirations are notorious for being weak in March, June, and especially September.  A lot of options open interest is concentrated in those quarterly expirations, and the rolling over of options positions/being less hedged make the SPX more vulnerable to selloffs.  Puts dominate the index options space, so when put open interest goes down, that means less put protection which means more fund managers are more likely to sell when markets are going lower, rather than staying still.  That's happening since Sep 15 quarterly options expiration.  Add into the bond market weakness and you have what you see on the screens.  

Don't believe those who are members of the Church of What's Happening Now about the bond market and its affect on stocks.  The stock-bond relationship is overstated in times like this.  Yes, all things equal, lower bond yields are better for stocks than higher bond yields.  But stocks focus much more on future earnings, and with most SPX companies having locked in long term rates at much lower levels, their future profits are not so negatively affected by higher bond yields as they would be in the past.  Also, one of main reasons the bond yields are higher is because the US economy is stronger than most expected, which means earnings expectations have gone up.  And with so much fixed rate debt (mortgages, corporate) in the US locked in at low rates, higher bond yields have a smaller effect on the economy than people think.  Probably the only thing I would worry about is the lack of bank credit that would result from these higher long term yields, as they pressure bank balance sheets and reduce the demand for credit.  But that would be something I would be more worried about at a 10 year yield above 5%, not here.  

On the intraday V bottom pattern:  they are not reliable.  In fact, they often lead to gap downs the following day and breaking of the intraday low in the following days.  We did see a lot of put volume on Wednesday which is necessary for the bottoming process.  GS Prime broker data has shown that hedge funds have sharply increased their short selling over the past week.  So the foundations for a tradable bottom are coming into place.  We also got much closer to the much talked about SPX 4200 support level, which is rock solid.  Based on the price action and the relatively low volatility (VIX is still under 20), its likely the SPX bottoms above 4200, probably somewhere between 4220-4240.  

You had a huge rally in June and July from 4200 to 4600, coming off a long term base that was between SPX 3800-4200.  August and September are consolidating those gains.  The fundamentals for the US economy has not changed much over the past 2 months.  Its still stronger than most expected at the beginning of the year, and you still have a lot of skeptics who think a recession is right around the corner.  Yes, yields are higher, but as I mentioned above, currently the US economy is not that interest rate sensitive.  

Its regrettable that I didn't put on a short position earlier in the month, even though I felt like ingredients for another selloff were there, including price action, seasonality, and the bond market weakness.  That would have been immensely profitable, even if I covered early around SPX 4300-4350. The clue to get short was the inability to V bottom towards previous highs around 4600 in September.  Held on to my previous view and didn't adjust as the market was showing weakness when it should have been stronger.  That opportunity is behind us, so on to the next one, which is to buy the dip.

The technicals are oversold, the fundamentals haven't changed much, and we are entering a period where the market usually bottoms.  I put on a starter long position in SPX/NDX on Tuesday, and am waiting to add more around SPX 4230-4250 in the coming trading days.