Fear and Loathing in the Bond Market

99% of investors have never seen such a long bear market in bonds.  The selling seems relentless, coming in waves, with only brief and shallow bounces.  It has been a wholesale repricing of future interest rate expectations, with more people getting skeptical about the Fed's ability to get down to their 2% inflation target.  Most investors now believe that any recession, if it happens, will be brief and mild, with the Fed not going down to 0% like the last 2 times there was a recession.  Those outcomes are certainly possible, and probably the higher probability outcome vs. a long, deep deflationary recession.  But at a certain point (may need another 30-40 bps selloff), the market will underprice a low inflation outcome, and overprice a high inflation one, making bonds too cheap, especially short term bonds.  

In the short term, I am less bearish on the US economy than the economists that I hear on CNBC and Bloomberg.  The tailwind from the big fiscal deficit is still carrying the economy in a high interest rate environment.  Another tailwind that is rarely mentioned is the surge in immigration in 2022:  

The number of people born somewhere else climbed by nearly a million last year, reaching a record high of just over 46 million, according to new estimates from the U.S. Census Bureau.   "The foreign-born population zoomed up," said William Frey, a demographer at the Brookings Institution in Washington, D.C. "The gain in 2022 was as big as the previous four years put together."

More immigrants not only means more labor but it means more demand for goods and services.  So the supply of labor has gone up along with the demand for goods and services.  You combine the big budget deficits with a big influx of immigrants, and everyone focused on tight monetary policy, and that is a recipe for a stronger than expected economy.  In recent months, you are finally seeing some people recognize the absurb levels of fiscal spending and deficit/GDP, and are connecting 2 plus 2 to figure out that its difficult to get a recession under those circumstances with such a tight labor market.  

This realization of a resilient economy that is less rate sensitive has re-priced the yield curve, with a bear steepening move that has put 10 year yields back towards the panic highs of October 2022.  The bond market is now in a 3 1/2 year downtrend, coming off of a 40 year secular bull market.  Gradually, fixed income managers are realizing that the previous bond market isn't coming back, and that supply and demand fundamentals are now much worse than they were in the previous 40 years.  The main reason is the US government.  When the government is addicted to deficit spending / tax cuts, without caring about debt or deficit levels, you have an unfavorable environment for bonds.  The enormous deficit spending and lack of tax revenue has brought huge amounts of Treasury supply into the market, which can only be digested at lower prices/higher yields.  Not only that, all of that Treasury issuance has goosed the economy by adding trillions of dollars into the economy that would otherwise not be circulating so freely, even with QT.  That keeps the Fed from cutting, which then puts pressure on the rest of the yield curve as the negative carry from borrowing short to buy lower yielding long term bonds reduces demand for long bonds, causing a bear steepening.  

Remember, the Fed did so much QE in 2020 and 2021, there is still a huge amount of money in the reverse repo facility which can be sucked out by QT without affecting the ample reserves in the system.  So QT is not tightening financial conditions.  Plus, once you get the reverse repo funds drained (will take about 18 more months at this rate), you still have a lot of excess reserves held by the banks that can be reduced without affecting interbank transactions or repo rates.  QT is not doing anything to the stock market because there is still so much excess liquidity in the system that is out there just parked at the Fed collecting 5+%.  

Of course, the origins of this comes from the outrageous fiscal and monetary policy in 2020, which laid the groundwork for this bond bear market.  For the bond market, it was short term gain, long term pain.   Despite the huge interest expenses racked up by all the national debt, politicians could care less.  They are all populists now.  On both the left and right, they pay scant lip service to the debt and deficits, and focus on ways to placate their core constituents by spending on clean energy, border control, defense, or just outright handouts like child tax credits or payroll tax holidays or pure tax cuts.  That's in addition to the natural increase in the deficits coming from the baby boomers entering retirement and collecting Social Security and Medicare.  Its just an explosion of deficit spending that will keep the long term trend of inflation higher and nominal GDP growth higher than in the past.  Real GDP growth down, inflation up.   

I remember when people actually cared about the size of the national debt, which kept politicians from going overboard on spending/tax cuts.  There was the famous national debt clock which gets no air time these days, but was a source of concern by many back in the 1980s and 1990s.  No one cares anymore.  

Eventually, you will get to a point where the economy slows down and can't handle the higher interest rates and the Fed will have to cut.  But probably longer than most people expect because a lot of businesses were bearish on 2023 and held back spending and investment until things improved.  So there is definitely some pent up demand that will be slowly unleashed in the next 6 months.  My best guess for when the economy slows enough to get the Fed to cut will be sometime in the summer/fall of 2024.   Next year, you have less spending at the state and local level, and the spending in the IRA and infrastructure bills will flatten out.  Capital gains tax receipts will be much higher in 2024 as stocks have gone up quite a bit since the start of the year. 

 Overall, the fiscal deficit as % of GDP should drop 2-3%.  That should be enough to slow down the economy and increase unemployment, which will put pressure on the Fed to start cutting ahead of 2024 elections.  Powell got re-nominated by Biden, and has no shot at getting re-nominated by Trump if he wins.  Don't forget that Trump hates Powell because he wasn't as dovish as advertised, and didn't yield to pressure from Trump to keep rates even lower.  So Powell will be incentivized to get political and help Biden win by cutting rates even before inflation goes down to 2% if he sees unemployment rising.  That should help the bond market in 2024, but that's a few months away so until then, there could be some more pain ahead as I don't expect the economy to get weak enough to support the bond market with all that supply coming down the pipe.  The 2-10s yield curve inversion is too steep for there to be much of a drop in longer term yields if the Fed stays steady.  The only reprieve will come with actual economic damage, and nothing else. 

So if bonds are weak for the rest of 2023, does that mean the stock market won't go up anymore?  No, not necessarily.  Stocks have rallied huge even as the 10 year yields have risen over 100 bps from the lows in April at 3.25%.  Bond yields are secondary to the stock market.  Earnings are the primary driver.  If a stronger economy keeps earnings expectations higher in the future, that helps stocks, regardless of higher bond yields.  So I could definitely picture a scenario where bond yields grind even higher and stocks going higher alongside it.  That's what happened for the past 5 months.  It has happened numerous times in the past.  Notably 2013.  2017.  2021.  And this year.  

The SPX is trapped in the middle of a range here, and volatility is dying.  VIX at 14 and realized vol even less.  The FOMC meeting on Wednesday has low expectations, and knowing Powell, he's not going to be giving away much here, being as mealy mouth and data dependent as possible, especially as he'll be on hold.  As we approach quarter end, you could see some rebalancing out of equities into bonds, so that could put some pressure on stocks in the next several days.  Had a big inflow into equity funds according to BofA in the week ending Sept 6, so investors are a bit sanguine here.  Also, JP Morgan fund hedge flows from the short call and long put spread being rolled over into December should require several billion of SPX selling by dealers to accommodate the rollover.  Don't like playing in the middle of the range, so not shorting this.  Overall, the flows look bearish for stocks here.