It has been a while since my last post. However, given the significant data releases that we have witnessed this year so far, including the impressive nonfarm payrolls report, slightly higher than expected inflation data, a rebound in services ISM and the solid retail sales, it is prudent to pause and provide an updated view on the rates market, which will ultimately impact the performance of risk assets that we are pondering as of now.
From the Pivot Trade to “Higher for Longer”
In February, the major economic data was nothing if not strong, Not only was hiring very strong in January, inflation very elevated in January, but also spending was very robust. The real economy is performing in such a way that will give the FOMC ample cover to continue raising policy rates and more importantly, retain a higher terminal rate for a longer period in this cycle.
On top of that, we saw the treasury market extended its bearishness, a impressive backup in 10 year yields from the 3.33% level. And the next primary uncertainty as it relates to the price action is the degree to which any further selloff beyond 390 through 4% or beyond can extend along with this latest down trade. Remember in January, the it trade in treasuries was pressing the Fed pivot and calling into question Powell’s commitment to bring rates above 5%, which is now given way to a resumption of the bear flattening trend that we’ve seen in the curve with 2s 10s back below negative 80 basis points this week and rates in the front end and belly of the curve the highest we’ve seen all year.
Taking Advantage of the Outsize Moves
It’s important to keep in mind that historically once the fed reaches the end of a cycle, whether it’s a hiking cycle or a tightening cycle, 10 year yields tend to hold a range of roughly 120 basis points. In that, I would expect this year to be defined by a range trade for 10 years centered at 3.50% with a range around the center point of plus or minus 60, 65 basis points based on the cycle high of 4.34% with a terminal of 6% priced in and the 3.33% low when the dovish pivot trade was so hot at the beginning of the year. That means it’s very reasonable to anticipate that at some point, whether it’s via renewed economic optimism or stubbornly high inflation, that a four handle will come to fruition, which will represent an important buying opportunity. On the flip side, whether it is a more quickly decelerating inflation profile and or a higher probability of a hard landing, it’s very reasonable to assume that a two handle for tens should be on the table as a risk if nothing else. Similarly, that would be an extreme that would warrant fading, i.e. selling 10s in that environment.
Let us not forget that the feedback loop between the equity market and overall financial conditions as the year plays out. Besides the fact that bond yields are an important determinant of equity valuations, the reality of higher borrowing rates for businesses and the lingering implications from the higher cost structures that have been established because of inflation during 2022, while firms were able to push through a portion of the higher input costs, they were not able to push through all of the higher costs. Instead, what we’ve seen is that the macro narrative continues to drive the compressions that come from valuation and profits for the pricing of risk assets. What’s been notable is that despite this dynamic, equities are not off as much as we might have otherwise expected. I would expect risk assets to experience a larger correction as 10 year continue to push through that 4% level. Again, as we learned in 2022, if employment continues to show resilience, a slow and steady grind of the equity market that contributes to the cooling down of inflation through the wealth effect is certainly welcome from a monetary policy perspective. While in the coming weeks, when the 4% of 10 year yield is breached and a meaningful amount of dip buying interest emerged, we will likely see a rally in treasuries, which will bring stocks back on the upward trend again. My ultimate trading bias for 2023 at least for the first couple of months remains to take advantage of the outsized moves to the range extremes.
Hard Landing vs. Soft Landing vs. No landing
It certainly was a defining week in terms of the price action itself and it certainly is not lost on me that at the beginning of this year when the it trade was bringing forward the Fed pivot, the conversation was hard landing versus soft landing. Fast forward to today and the conversation has shifted to soft landing versus no landing. I certainly don’t think that this is warranted given the amount of cumulative policy tightening that has already occurred, not only in the US but also globally. There is a lag between the actions of global central banks and the impact on the real economy and the market seems to be content to assume that that has already filtered through the system. As Jeremy Grantham said earlier that at this stage, there are more things that can go wrong than there are that can go right globally.
Now we still have more than a quarter point of easing assumed by the market. I will caution against interpreting the 25 basis points of easing seen in the Fed fund’s futures market as 100% probability that the Fed is going to cut by a quarter point. Instead, I will go with the interpretation that it’s either a 25% probability that they’ll need to ease by 100 basis points or a 12.5% probability that they need to cut by 200 basis points by year-end. Now, in the latter scenario that would clearly imply a much more significant economic downturn and a Fed that was forced into action long before they currently anticipate. So that being said, when and what would it be?
All About Macros 