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Even the Good Outcome is Bad

An astute English friend noted overnight that so much IQ is focused on linguistic and microanalysis of what the Federal Reserve may do, which is only a responsive derivative of what really makes the financial world tick. That is everything that’s wrong with markets. Too much introspection. Not enough extrospection. Put another way, in 2020 the Fed communicated that “we are not even thinking about raising rates”. The Fed then proceeded to hike rates by 525 basis points. In 2023, “we are not even thinking about cutting rates”…. From our humble perch, given the weakness in key leading indicators and the tightening in broad financial conditions, the Fed will probably be forced to cut the funds rate by at least 200 basis points next year.

As we noted yesterday, the big picture question at the November FOMC meeting was how much of yield increase at the long end of the yield curve reflects changed expectations on growth and how much could restrain future growth by tightening financial conditions. Our sense is that the tightening in broad financial conditions has been meaningful given the rise in mortgage rates and corporate debt tied to long rates. While that is not evident to several market participants, the impact is visible in the tightening in lending standards, deterioration in specific segments of the credit markets (CCC, MBS and CMBS spreads) in in the performance of bank and other cyclically sensitive equities. Indeed, based on a few “real economy” variables financial conditions are probably even tighter than what is indicated by market based financial conditions indices.

From our perch, the more important macro new flow overnight was the renewed weakness in the US manufacturing ISM index (chart 1). The key point is that the weakness is global: growth in many other countries has also surprised to the downside. Second, the duration of the weakness is now over 12 months. Third, the weakness is broad across thirteen industries. Fourth, the weakness was evident in leading sub-components (new orders) and employment. As we have noted recently, a key to the Fed’s reaction function on a forward-looking basis is employment. Several of the leading indicators of employment such as job openings, temporary hires, ISM employment (noted above) and consumer confidence surveys are consistent with a meaningful easing in the labour market that would necessitate the Fed to cut rates.

For markets, the rapid and emotional or non-linear rise in fixed income yields since 2022 has been catastrophic for long duration fixed income. The drawdown in the TLT long bond ETF has been over 50% from peak which is comparable to the 2008 bear market in equities. It will also be the third consecutive annual decline in fixed income returns. That is the first time in history going back to 1928. While the level of fixed income yields is still not as extreme, the extremely low starting point for interest rates in this episode contributed to the large drawdown in bond prices (values). The other notable feature of this bear market is the flip in the correlation with equities. This has clearly been an inflation-driven bear market. As a result, fixed income has failed to provide diversification for equities.

Looking forward, if the Federal Reserve is forced to cut the funds rate next year by 200 basis points (or more) bond yields are likely to fall (bond prices rise). While equities might enjoy the decline in yields (and the discount rate) in the initial phase, the implication of the rate cuts is a probable deterioration in growth and profits. In that context, the equity and credit risk premium are probably too narrow in US equities or on the global risk proxy (S&P500). Stated differently, the odds probably favour out-performance of sovereign bonds over equity.

Ironically as we noted recently, the “good outcome” is that the current cycle ends in recession, equity and credit markets crash and there is renewed demand to buy Treasury bonds. The bad outcome might be a renewed phase of inflation with no willing buyers (at the current price) for sovereign bonds and yields rise even further. Our sense is that the former is more likely in the near term and the odds increasingly favour a long-fixed income and duration position. In summary, Treasury yields tend to fall (bond prices rise) when the Fed cuts rates.


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