Bond Brakes

The bond market is putting the brakes on the stock market.  It was smooth sailing with the weaker economic data for the past 2 months but now that weakness has been priced in.  You started to hear more optimism on bonds and less optimism on the economy.  But that has run its course.  The economic expectations have been lowered, meaning that it will be easier for data to beat expectations, creating negative catalysts for bonds.  That has made Treasuries vulnerable to profit taking for any reason, even for something as far off as a higher probability of Trump getting elected.  

The knee jerk reaction from last week's debate was that Trump is more likely to win in November, meaning that you are more likely to get the Trump tax cuts extended, as well as having even more tax cuts on top of that.  That would blow out the budget deficit even more, and stimulate the economy creating more inflation.  Add to that the potential tariffs, as well as a tighter labor market coming from less immigration, and you have an inflationary mix that bond investors are revolting against.  

While I agree those policies are inflationary, I don't agree that Trump will get much done. He doesn't seem like a guy who is all that interested in policies, or passing a bunch of bills.  It was really the Democrats working with that closet Democrat Mnuchin, which resulted in that giant Covid money spew through the PPP program as well as assorted other handouts.  He's just a guy who enjoys being in the role of President, and the power that it entails, and using that power to enrich his cronies/family/himself in the process.  He seems obsessed with the stock market, so I don't think he'll try to fight the bond market because that is in essence fighting the stock market by trying to introduce super inflationary policies.  Overall, he probably doesn't get much done, and its basically the status quo, which is a stagflationary economy that is weakening slowly but unlikely to go into a deep recession due to bloated  fiscal policy.

What we saw the last few days isn't quite the return of the bond vigilantes, but with so much supply coming down the pike with the huge fiscal deficits, the bond rallies don't seem to be able to last for more than 2 months or so.  10 year yields have gone from 4.7% to 4.2% from late April to late June, so you've had your 2 month rally.  All those hard fought gains from bond investors over the past 2 months, gaining 50 bps, half of those gains have been lost over the past 4 trading days.  Hard come, easy go.  That is the definition of a weak market.  

You had some who were reluctant to be short Treasuries and Bunds due to the well telegraphed weak PCE number on Friday and the French parliamentary elections on Sunday.  Once that turned out to be a nothingburger, the risk off bid for Treasuries immediately disappeared.  Treasuries are not the risk off asset that they used to be.  The bids are fleeting, and you have to be extremely quick to take profits on the risk off rallies, because they just don't last for long.  Its the opposite of what you had from 2008 to 2020.  Those Treasury rallies lasted and lasted, and lingered near the highs, giving bond holders lots of time to sell the highs.  No longer.  The nature of the market has changed, with stock/bond correlations positive, making Treasuries a poor hedge for long equity exposure.  Instead of hedging risk, Treasuries have added risk during stock market selloffs since 2021.  

This has long term implications for financial assets and portfolios.  Investors will have to take less risk on the equity side and the fixed income side due to these correlations.  Long term, I find it hard to imagine a world where you have multi trillion dollar deficits during an economic expansion while maintaining low bond yields, high equity prices, and a strong dollar.  If the Fed wants to keep asset prices high, it will have to keep yields artificially low by either having negative real interest rates on the short end, or by restarting QE and pushing long term yields artificially lower.  The dollar will be the release valve in this situation, and will weaken substantially, which will help to contribute to higher inflation through more expensive imports and more bank lending which increases the money supply.  

Once you blow out the fiscal deficit to high single digits % of GDP, the free lunches go away.  Fiscal stimulus results in limited to no real growth, with most if not all of the nominal growth coming from inflation.  When you have inflationary policies and are unwilling to control the deficit, the population eventually picks up on the game, and act accordingly.  Sellers raise prices more quickly, and in bigger chunks.  Buyers will begin to hoard or try to get rid of paper dollars as quickly as possible if these inflationary policies continue.  Dollars will eventually become hot potatoes, like Argentine pesos are now.  We are not yet in the hoarding/immediately convert paper to hard money stage, which is Argentina type stuff, but its not too far away with this deficit trajectory.  The politicians are of course asleep at the wheel, continuing to pander and do whatever it takes to get re-elected, which is to give out goodies/cut taxes.  The exorbitant privilege of having the reserve currency let's the US get away with these policies for longer than any other country in the world, but foreigners will eventually revolt by selling dollars.  

Will voters start caring about the budget deficit and demand more fiscal discipline?  Only if they feel pain from the high budget deficits.  You need to see sustained, high inflation, double digit inflation year after year, and higher bond yields resulting in higher mortgage, credit card, and auto loan rates.  You saw a preview of that in 2021 and 2022, but it still hasn't gotten through to the thick heads of the American public, who still want their tax cuts, student loan cancellations, Social Security and Medicare benefits, and whatever other stimmies the politicians throw at them.  No one wants to experience short term pain anymore, so they will have to accept higher inflation as a result.  And it still seems many out there can't seem to put 2 and 2 together, and still blame supply chains for the higher inflation, instead of all the money printing that happened. 

Back to the current markets.  I am sensing weakness in NVDA vs the rest of the tech sector, as it seems the AI bubble got a bit ahead of itself in June.  You are still seeing Russell weakness vs the SPX and NDX.  Its still the same crap market underneath the shiny veneer of a low volatility, safe looking broader market.  That hasn't changed.  What has changed over the past few days is the bond market uptrend coming to a violent end, taking the SPX and Russell 2000 down with it.  That makes me even more bearish than I was previously, but am waiting for any short term rally to put on shorts.  Perhaps July 4th holiday bullishness will ignited a little rally to sell into.  An SPX rally towards 5500 to 5520 would be a gift to short.  Hoping for that rally within the next few days, perhaps on weaker nonfarm payrolls or a cooler CPI next week.  This market looks very vulnerable here.  Its just a matter of getting a good short entry.