The decline in Treasury yields (rise in bond prices) since late October has been impulsive, rapid, and emotional. Suddenly all the slack in the labour market has vanished and bond supply fear has faded (sarcasm intended). As we have noted for some time, there have been visible cracks in the labour market for several weeks. Job openings have collapsed, continuing claims have trended higher, temporary hires have rolled over (a leading indicator of total employment) ISM employment sub-indices and net jobs plentiful within the consumer confidence survey have all deteriorated. Employment itself has been revised lower for nine consecutive months. The unemployment rate has also increased from 3.4% to 3.9%. The arithmetic of 4.5% unemployment appears more likely.
We are also not surprised that there has been a relief rally in equities given the shift in consensus beliefs on inflation and rates. The first 50 basis points fall in long rates reduces tension on the equity risk premium and eases broad financial conditions in a reflexive or self-reinforcing way by putting downward pressure on the dollar and upward pressure on equity prices (chart 2). However, the first 50 basis points (or so) are like a drug addict’s first hit. It’s all thrills. The following 50-100 basis point drop in rates is likely to signal recession and the addict’s (stock market) descent into a long tunnel of pain. The implication of a sharp deterioration in the labour market is the correlated deterioration in growth and profits. That is probably not bullish for equities.
The December 2024 Implied SOFR Yield is now down by around 100 basis points from peak. That is a non-trivial decline in rates. However, in a recession, the Fed will be forced to cut the funds rate by 250-300 basis points. The prevailing bias on rate cuts is probably inconsistent with the consensus belief in a “soft landing” according to the Bank of America Fund Manager Survey.
As we noted before, human beings are not particularly good at non-linear thinking. From our perch, a key reason why there is resistance to consider extreme (or non-linear) outcomes like monetary policy reversals, inflation persistence, acknowledgement of higher neutral rates, depletion of inventories and wars is that most investors are short convexity. The real world is not linear and systemic risk can increase at an accelerating rate as correlation moves to one in a major episode. It also generally benefits most financial market participants when asset prices rise, not when they fall.
While a “soft landing” is plausible, the weakness in key macro news flow has been broad (across thirteen industries in the ISM surveys) and in the key leading indicators on the labour market. The US Conference Board Leading Index remains extremely weak. It has only been weaker in the 2008 episode. As we noted above, the key leading indicators of the labour market are probably consistent with 250-300 basis points of rate cuts by the Fed. However, it will remain dependent on the speed of deterioration in the labour market.
In conclusion, the employment report on Friday and trend news flow on the labour market is likely to remain critical to the Fed’s reaction function. The decline in Treasury yields has already been material. The US long bond ETF TLT has already gained 14.8% from the October low. However, if the Fed is forced to aggressively cut rates next year, there is considerably more upside still. Moreover, in that environment bonds are also likely to provide diversification for the probable drawdown in equities from the likely growth scare.