2024-12-09 22:05:32
Looking back at the 2015-2021 period when I traded bond markets at a large bank, it was quite boring.
Rates were mostly stuck around 0% at the front-end, and to make money you had to find small dislocations and monetize them with leverage hoping volatility would remain low forever.
Today, the story is different: bond markets are truly exciting.
So let’s have a fresh look at them.
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I expect the Fed to cut rates again in December.
Why?
See the chart below:
Even after the recent Fed cuts, today’s Fed Funds (orange) are still markedly above the underlying trend of core PCE inflation (blue).
The Fed is a simple animal: their dream is to have a stable labor market with predictable inflation.
And today, the main risk they see isn’t an inflation pick-up.
Instead, risk management forces them to protect the US economy against a deterioration in the job market.
Running a real Fed Fund rate (bottom chart, black) at +2% for several quarters on end is an exercise which was last performed in 2007.
I don’t think the Fed sees major benefits in running such a tight policy.
Hence, I believe they will cut rates by 25 bps in December.
But here is an argument for them to feel confident the US doesn’t need a major cutting cycle in 2025:
This chart looks at the US private sector (orange) and government (blue) debt to GDP since the 1990s.
It’s an incredibly important chart to approach US bond markets today.
The US went through two clear macro phases before today.
In phase 1 (before GFC), the US government refused to lever up: government debt as a % of GDP was at or below 60% and deficits were seen as a bad thing.
As the private sector didn’t receive any stimulus from government deficits and it grappled with declining demographics and productivity, it used leverage to achieve higher growth.
In phase 1, the US private sector was forced to lever up aggressively.
Until in 2008 excessive private debt and loose credit standards led to the Great Financial Crisis.
This kickstarted phase 2 of the long US macro cycle – the post GFC period.
Between 2009 and 2012 the US government printed money (read: deficits) to stabilize the US economy.
This allowed the US private sector to de-leverage: private sector debt as a % of GDP fell below 150%.
But this fiscal profligacy didn’t last for long: between 2014 and 2019 the US primary deficit as a % of GDP was less than -2% on average – mildly supportive for the private sector, but nothing special.
So we sat there in this limbo of acceptable GDP growth, but as neither the US government nor the private sector levered up aggressively we lived through a ‘’meh’’ US growth cycle.
Finally, C-19 hit and the game might have changed for good (phase 3).
Since 2020, US deficits have exploded and this has allowed the US private sector to de-leverage.
US private debt as a % of GDP is now the lowest since 2003 (!).
So: why does this matter for bond markets?
Because in a world with less private sector leverage, ceteris paribus interest rates can be a bit higher.
When there are less mortgages and corporate loans to refinance vis-à-vis higher nominal wages and earnings, the equilibrium interest rates at which the economy can function should be higher.
The flipside is obviously that an increasing load of government debt will have to be refinanced at higher rates.
In the US case though, that’s more manageable than for other countries due to the reserve currency status.
This is why the market feels quite strongly about terminal rates being well above 3% this time.
As per today, markets expect Fed Funds to still be at 3.50% in 3 years from now.
The most important implication for investors is this.
If the Fed embraces this new narrative, we are looking at few (if any) cuts left in 2025.
This is because if neutral rates are considered to be higher, the Fed doesn’t need to cut rates much more to achieve a neutral policy stance.
With euphoric expectations about earnings growth, nosebleed valuations and a less friendly Fed overly bullish investors might be disappointed in early 2025.
This was it for today. I hope you enjoyed this macro piece.
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2024-11-29 17:14:28
Hey, this is Alf speaking - welcome back to The Macro Compass!
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Now, to the piece.
Trump is back slashing (or should we say: threatening) tariffs left, right and center.
The more gradual approach suggested by his inner circle is nowhere to be seen.
It seems like this Trump presidency will bring more volatility than the previous one.
And if you think about it, it actually makes sense.
Controlling the House and the Senate, Trump is empowered to run his last and more aggressive agenda: in Musk’s words ‘’it’s now or never’’ for implementing policies.
I feel like Trump has little to lose here, and he is calling the shots.
When it comes to markets, I believe it’s good practice to look at what happened in 2016.
The world isn’t the same, but Trump’s policies seem to move broadly in the same direction and even if history doesn’t repeat it often rhymes:
The chart at page 1 shows the Sharpe Ratio for the top 7 risk-adjusted trades in the 45 days subsequent to Trump’s surprise win in 2016.
We chose risk-adjusted returns over absolute returns to avoid giving an advantage to highly volatile assets like Bitcoin – in absolute return terms, the most volatile asset will always prevail given favorable conditions.
The 7 trades all make sense from a macro standpoint.
Stock markets and in particular small-caps and banks benefit from Trump’s economic and de-regulation agenda; yields move up as nominal growth is seen increasing; the USD strengthens against low yielders and countries hit by tariffs and Bitcoin acts as the perfect de-regulation friendly, animal spirit asset class.
Let’s now look at today.
We overlapped the 2024 performance with the 2016 performance for the top 7 ‘’Trump trades’’.
In choosing the ‘’day 0’’ for 2024 we opted for the day when the Republican sweep odds moved above 50% on Polymarket: at that point, a Red Wave was already priced as base case similar to November 9th 2016 when it was clear Trump had won.
Here is how the ‘’Top Trump Trades’’ look priced today:
Here are 3 observations from my side:
1) Trump Trades in the stock market are experiencing a milder rally than in 2016;
2) The FX market seems unimpressed too;
3) Bitcoin has front-loaded all the 2016 gains in less than half the time.
Every time there seems to be an obvious trade we should always ask ourselves why should it be so easy.
In this case: can we safely assume there is a lot of juice left in USDMXN or stocks?Has Bitcoin already run its course?
For the Trump Trades in the stock market, one reason why we are lagging behind could be valuations.
The S&P500 wasn’t nearly so expensive in late 2016 from a forward P/E perspective, and therefore a long stock position here relies heavily on earnings to deliver as valuations are already high.
In FX, I can explain USDJPY – the Ministry of Finance in Japan limits the upside there.
But why would USDMXN not trade much higher as it did in 2016?
It seems FX markets are leaning towards tariffs being used as a negotiating mechanism rather than actual sizable tariffs being imposed on several countries in the end.
I think FX markets are largely underestimating Trump 2.0 and the volatility he will bring.
But also remember that in the medium term, macro conditions >>> reaction to short-term political agendas:
The chart above broadens the perspective on Trump Trades and it looks at 180 trading days after a Trump victory became clear in 2016 and 2024.
Notice how:
- US banks and small caps almost flat-lined after the initial enthusiasm, while the S&P500 kept going
- A short 10-year bond position lost money after the initial burst
- USDMXN longs ended up losing (!) money after 180 trading days
- Bitcoin kept going vertical and the punchiest part of the rally only happened much later
In 2017, global economies exhibited a miraculous concerted global growth amidst disinflation.
When it comes to 2025, I am not so sure that should be the base case.
I think Trump 2.0 is very much focused on foreign policy, and that this time around tariffs will become an important macro theme that stays with us for a long time.
If I am right, Trump 2.0 might sacrifice some short-term growth in exchange for harsher tariffs to pressure foreign economies to ‘’rebalance’’.
The outcome would be an increase in short-term inflation expectation but coupled with weaker growth, and a Fed likely to ‘’look through’’ the inflationary threat from tariffs to protect the US economy.
If that unfolds: most financial assets suffer, bonds do ok, the USD acts as a hedge.
This was it for today, thanks for reading.
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2024-11-01 15:36:35
Good morning and welcome back to The Macro Compass. This is Alf writing.
It’s almost been 3 years together now - and I loved every little bit of it.
I treasure each and every supportive comment you threw at me, and vividly remember hitting 100,000 subscribers and jumping out of joy. We are now 150,000+. It’s crazy.
But.
As I run two businesses now (my hedge fund Palinuro Capital and The Macro Compass), I need to focus on my customers even more.
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C) This could be it. Next year we might close to new subscriptions.
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As we are getting a large influx of institutional demand, next year we might be closing subscriptions at retail-friendly prices.
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Now, to the piece.
The Bond Market is saying “This Time is Different”.
The Term Premium is on the rise, and it now sits close to the highest level for the last 10 years.
But What is Term Premium?
An investor looking to get fixed income exposure can do that via buying 3-month T-Bills and rolling them each time they mature for the next 10 years.
Alternatively, it can decide to purchase 10-year Treasuries today.
What's the difference?
Interest rate risk!
Buying a 10-year bond today rather than rolling T-Bills for the next 10 years exposes investors to risks – term premium compensates for this risk.
The lower the uncertainty about growth and inflation down the road, the lower the term premium and vice versa.
Uncertainty is the key word here!
The higher the uncertainty about future growth and inflation, the higher the term premium.
The left chart below shows how term premium (y-axis) increases with a higher dispersion of forecast (read: uncertainty) for inflation (x-axis):
Today the estimates of the US Term Premium have moved higher and they are now testing the upper side of recent ranges: in other words, there is some more uncertainty being priced in about the path ahead for growth and inflation.
Investors are less confident about a future of predictably contained inflation and growth, and they expect some more volatility and uncertainty down the road.
As we approach US elections, bond markets are telling us - yes, “this time is different”.
Persistent fiscal deficits regardless of who wins US elections can lead to more volatile inflation backdrops, and to more boom/bust cycles.
But as Term Premium is on the rise, should we fear the return of Bond Vigilantes?
Not so fast.
This week, Bond Vigilantes are in action in the UK: the fiscal budget unveiled by the new UK government has been assessed as ‘‘too loose’’, and therefore investors are going after all UK assets - they are selling GBP, selling UK bonds, and even stocks.
Bond Vigilantes are truly in action when they initiate a sell-off in bond markets to impart discipline to policymakers, and they hence generate a spill-over effect to the currency and potentially stock markets too.
But the US is not the UK.
Over the last 40 years, Bond Vigilantes have NEVER been in action in the US:
Over the last 40 years, we never really had investors puking on US assets - true Vigilantes are in action when both bond yields go up, and the USD goes down.
As you can see from the chart, that quadrant is basically empty.
We are instead experiencing people pushing US yields higher and the USD getting stronger. The bond market is hence sending a different message.
''Trump's policies will be stimulative for nominal growth, and the US will grow faster than other countries''.
Additionally, investors are hedging for a scenario in which rates move up fast via options. This is evident in the so-called ''skew'':
This means investors are willing to pay more for bond puts than for bond calls for the next month.
This is unusual: investors normally pay more for ''insurance premium'' (bond calls) than for puts, so this is related to election hedging.
There are no ''Bond Vigilantes'' in action here.
Instead, the bond market is preparing for a Trump victory and for policies that will be stimulative for growth and inflation.
Yet, history shows us this.
Elections are a powerful short-term volatility event.
But macroeconomic cycles tend to prevail over time.
Trump was the President in 2019 as well, but as the global macroeconomic cycle was weak 10-year Treasury yields traded as low as 2%.
If Trump secures a sweep, I expect the bond sell-off to accelerate.
Your mother and your dog will tell you to sell bonds at 4.50% yields.
That’s when you should consider buying them instead.
And don’t forget: today you should go for it.
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Enjoy your weekend,
Alf
2024-10-20 23:33:12
The key macro event of 2024 is approaching: US elections are around the corner.
Next week I will release a deep research piece on US elections, which will be centered around the key questions looming large.
How to trade different scenarios?
What happens to markets if Trump secures a Red Sweep?
And what asset classes to prefer if instead Kamala wins?
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Macro clouds remain on the horizon.
Wherever you look at, you see unsustainable economic models: we are either relying on debt-fueled growth (US), trying to squeeze exhausted growth models (China), or succumbing to a slow and painful death (Europe).
Today, let’s take a step back and talk about the business models that Europe and the US are pursuing.
Let’s unpack them together, and understand what lies ahead and how to prepare portfolios accordingly.
Europe is slowly dying.
To prove my point, here is one of the most depressing chart you'll see today:
The chart above shows an uncomfortable truth for Europe.
ECB's Professional Forecasters now expect 5-year GDP growth in Europe to come in at only 1.3% - the lowest level ever.
Prior to the Great Financial Crisis, this number used to be consistently above 2.0% in real terms.
So while we are talking about the ''Roaring 20s'' for the US, and while we are watching countries like India perform particularly well we are left to answer some tough questions in Europe.
Why is growth so low, and expected to remain so sluggish?
1️⃣ An imperfect European infrastructure, and no improvement in sight: we run a ''union'' under one monetary policy, different fiscal policies, and without a banking or capital markets union.
2️⃣ Poor productivity, and no structural reforms: while touted the whole time, European politicians are really not busy with reforms to structurally improve productivity.
Over the last 20+ years, European productivity growth has been a meagre ~1% per year.
The US is becoming increasingly more productive at a much faster pace:
3️⃣ Bad demographics, and worsening;
Low birth rates imply that Europe will see its labor force shrink by 25% (!) over the next 20-30 years:
Not only that - it’s also a matter of putting people to work in the first place.
In Italy, women labor force participation rate is not even at 60%.
4️⃣ No appetite for true innovation, and instead an insatiable appetite for more and more regulation
Europe is slowly dying.
Yet markets are still in La-La Land.
This week, the ECB cut interest rates once again but nominal rates remain still too high versus the underlying trend in inflation.
As the chart below shows, Europe instead needs interest rates below (!) the level of inflation to have a monetary policy loose enough to stimulate at least some growth:
The chart below is another way to picture this inconsistent bond market pricing.
The long-run equilibrium nominal rate represents the nominal interest rate that allows an economy to operate smoothly and deliver its potential growth rate while inflation hovers around 2%.
Think of it like the interest rate which ‘‘balances’’ the economy.
Prior to the pandemic, the average pricing for the long-run equilibrium nominal rate in Europe was +0.5%.
Today, it’s over +2.0%.
What has changed in Europe so that the economy can structurally handle higher interest rates way better than before the pandemic?
In my opinion: nothing.
If anything, things look a bit worse now:
Patient Europe is dying.
Better make sure your portfolio is prepared for it.
Let’s chat about the US economic model now.
Here are some staggering statistics about the US economy - since mid-2020:
1) US nominal GDP has grown by ~7 trillion
2) US total debt has grown by ~8.5 trillion
Debt-fueled economy, debt-fueled growth:
Look at this excellent chart from E.J. Antoni.
It shows how US nominal growth (blue) has increased less than the increase in federal government debt (red).
If you add in private sector debt, the red bar crosses the 8 trillion mark.
Should we worry about this debt-fueled growth model?
Look: our monetary system is centered around debt/credit creation to sustain economic growth. There is nothing inherently bad about that, but the key is to use new debt to fund productive investments and reforms.
We got worse and worse at that:
As the chart above shows, for every new $ of debt we end up creating way less than a new $ of GDP growth!
So: yes, the US economy has done incredibly well since 2020.
But more than organic growth, this is once again debt-fueled growth.
Whoever wins the US Presidential Elections, you can rest assured there will be more and more debt creation to try and fuel US economic growth.
Can this model continue to thrive?
I’ll cover this in next week’s flagship US election research piece.
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2024-09-28 20:16:00
The Chinese real estate market is de-leveraging very hard.
Economists estimate Chinese households have suffered $10+ trillion of wealth losses as a result.
There is now a strong urge to stop the bleeding amongst Chinese policymakers.
Last week, China unleashed a ‘‘stimulus bazooka’’.
But what were the measures all about?
And will they be effective to fix the Chinese economy?
Chinese policymakers announced the following package:
A) More interest rate cuts
B) The Chinese version of the ''Fed put''
C) Vague wording about fiscal stimulus
Interest rate cuts and the ''backstop'' facility are propping the Chinese stock market to the moon.
Yet they are very unlikely to work in a balance sheet recession.
In the 90s, Japan cut rates aggressively and that wasn't the solution to the problem:
Cutting rates won’t encourage households or corporates to leverage: corporates were tapped out in 2016 already, and households have just been burnt with excess debt so we shouldn’t count on them.
Lowering interest rates in combination with the new ‘‘PBOC Put’’ can instead help reinstate animal spirits.
Chinese authorities set up a BTFP-like facility which allows you to pledge collateral (cash, bonds etc) and get funding to go and buy Chinese stonks.
Yet, this is unlikely to solve the structural malaise affecting the Chinese economy.
Fiscal is the only real fix, and here is why.
There have been 3 key phases of Chinese leverage:
1) Corporates (red)
2) Households (blue)
3) And now fiscal is the only solution (orange)
10 years after entering the WTO in 2001 and once the demographics dividends were exhausted, China embarked in massive leverage to sustain their growth targets.
Phase 1 saw Chinese corporates (red) tap up leverage aggressively (2010-2016).
Once corporates’ appetite for debt was exhausted, Xi Jinping tapped Chinese households (phase 2).
This led to the creation of a massive real estate bubble which China is trying to deflate now.
The only agent left to pick up the slack is the Chinese government – fiscal deficits are key here (phase 3?).
So while the ''bazooka'' has been excellent at restoring market confidence, there is only one real fix for the Chinese economy here.
It's a large, large fiscal stimulus package.
Will China actually implement it?
Reuters ran a piece discussing a $284 bn fiscal package.
This would be very much unlikely to sort things out.
Size matters here: consumers and corporates have been hit by a $10 trillion de-leveraging in the housing sector, and so the fiscal stimulus needs to be large and targeted to make the difference for the Chinese economy.
While we keep monitoring any concrete announcement on fiscal stimulus from China, it’s worth remembering how Chinese policymakers love a ‘‘counter-cyclical’’ Bazooka:
China loves to stimulate (for real) when the global economy is weak.
This way, they can get the best ROI on their money creation and go buy cheap foreign asset/strengthen their trade position/gain shares in crucial markets.
Until the global economy slows down further, China might not be interested in proper stimulus but rather in ''controlling the bleeding'' and get investors occasionally stopped out in their China shorts - a story we've seen happening for 18 months already.
China matters for the world.
China needs a large fiscal stimulus.
Large. Fiscal.
These are the two key words you should be focusing on.
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2024-09-20 21:54:34
The news of the week is NOT the Fed cutting 50 bps - yes sure, that’s important but there is something much more relevant going on.
The Chinese economy keeps imploding from within.
And we should pay attention.
The Property Price Index for Chinese tier-1 cities keeps making new lows, and it’s now approaching levels last seen 8 years ago!
At this point you might ask yourself: well, is it so bad if house prices drop a bit?
In standard circumstances I’d tell you this is not a disaster.
But for Chinese people, things are different:
Chinese households hold 60%+ of their wealth in Chinese properties.
This is way higher than in the US, where households only hold 23% of their wealth in properties while the majority sits in the stock market or retirement plans.
Now imagine if your stock portfolio dropped back to 2016 levels.
How would you feel about it?
That’s how Chinese households are feeling!
But why is China imploding this fast?
It’s because Xi Jinping wants to engineer a new ‘‘common prosperity’’ economic model which relies less on leverage, tech bubbles, bridges in the middle of nowhere and frothy house prices and more on internal consumption.
The problem is that when you deleverage a 50 trillion (!) worth real estate market inflated with absurd levels of leverage…well, that’s not an easy task to achieve.
China is cutting interest rates aggressively to try and limit the slowdown: Chinese 10-year interest rates just dropped below 2% for the first time..ever?
Yet cutting interest rates while the real estate market is deleveraging won’t help much.
Ask Japanese people in the 1990s for reference:
China keeps imploding from within and this matters for the rest of the world.
For example, China is the number 1 trade partner for many countries and for specific jurisdictions it represents a very large importer for the commodities they produce.
See Brazil for instance:
Everybody is talking about the Fed.
But the real macro mover to watch here is China.
Keep it on your radar!
And of course - who am I not to spend a few words on the Fed as well.
This week's 50 bps cut was initially celebrated by markets: after all, if the Fed proceeds with such a sizable cut what's not to celebrate?
The problem with such a simple narrative is that the Fed's monetary policy needs to be measured against the underlying growth conditions.
Fed Funds at 4.75% can be:
- Still loose: if the US economy is running ultra-hot
- Still tight: if the US economy is rapidly weakening
In other words: the monetary policy looseness/tightness needs to be measured taking into consideration the ongoing economic conditions.
The chart above does just that, and it compares Fed Funds (orange) with the underlying trend of US nominal growth (blue).
The US nominal growth proxy is built using core PCE - the Fed's official target for inflation - and the NBER gauge for US real economic growth.
Why the NBER gauge and not real GDP?
Because the NBER is the body that ultimately determines whether the US is in a recession, and they do so using a broad basket of 7 indicators tracking every sector of the US economy (from consumers to industrial production to the labor market).
The outcome of this analysis is straightforward.
There is nothing to celebrate.
The Fed's policy is still dangerously tight.
As you can see, it only rarely happens that Fed Funds (orange) sit close or even above US nominal growth (blue) for a prolonged period of time.
And when that happens, it's never good news for the economy.
The Fed needs to do more.
Or it risks falling further behind the curve.
If you enjoyed this piece, you should know I launched a YouTube channel for my weekly show The Macro Trading Floor with Brent Donnelly.
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