2024-11-01 15:36:35
Good morning and welcome back to The Macro Compass. This is Alf writing.
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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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2024-09-10 17:46:31
We are observing a true regime change in markets.
And for macro investors, it’s incredibly important to stay vigilant and on top of our game at this stage.
It all starts with this: the Fed is behind the curve, and it is playing with fire.
Consider this.
The recently released US job report showed the US private sector is only adding an average of 96,000 jobs per month over the last 3 months.
Such a weak pace of job creation has last been seen in summer of 2007.
The last CPI report also showed another friendly and disinflationary print: core CPI raised less than 0.2% on a MoM basis which is a trend in line with pre-pandemic ~2% yearly inflation trend the Fed targets.
So, why is the Fed playing with fire?
The chart below shows you why.
Fed Funds at 5.25% while core PCE is convincingly sub-3% represent a real Fed Fund rate of 2%+.
Real rates are what matter for the economy:
Investors care about their (risk-free) returns after accounting for inflation
Debtors care about their inflation-adjusted borrowing costs
With real rates now at 2%+ for quite some time, it's important to look back at past episodes and see what happened when the Fed forced such a tight policy for too long:
A) In 1999-2000, the Fed kept real rates at 3%+ for a sustained period of time and a crisis unfolded in 2001;
B) In 2007, the Fed kept real rates at 2%+ for a while and a crisis unfolded in 2008;
C) In 2024, the Fed is keeping real rates at 2%+ and...you get it.
On top of this, the Fed is also keeping policy very tight while the US job market is showing clear signs of weakness.
The Fed is behind the curve, and it is playing with fire here.
And when this happens, the bond market takes over.
The chart above goes back to 1989 and it looks at the amount of rate cuts/hikes bond markets were pricing for the subsequent 2 years.
I focused on periods when the bond market was very, very dovish and it priced in a robust amount of cuts.
The big question is: what did the Fed ACTUALLY deliver?
Did one make or lose money by buying bonds when markets were already super dovishly priced?
Let's look at the data:
1️⃣ January 1995, October 1998
Cuts priced for the next 2 years: on average 130 bps
Cuts delivered by the Fed: 75 bps
If you bought bonds while markets were already at peak dovish pricing, you lost money (cuts delivered were less than priced in).
2️⃣ January 1990, December 2000, September 2007, August 2019
Cuts priced for the next 2 years: on average 145 bps
Cuts delivered by the Fed: 412 bps (!)
If you bought bonds while markets were already at peak dovish pricing, you ended up making a ton of money.
The results are very interesting.
As a rule of thumb, I always advocate that in macro you don’t make money by only ‘’being right’’.
That’s a necessary but insufficient condition: you also need to surprise consensus, or in other words see something before the crowd does + position correctly for it + monetize when they converge to your view.
Yet it seems like the bond market is quite good at sniffing when something is about to go wrong.
The bond market is sending a loud message: are you listening?
But it’s not only about the bond market here.
It’s also about cross-asset correlations suggesting tectonic shifts are happening:
We are witnessing a massive regime change in markets.
Recently we experienced another large drawdown in equity markets lead by tech stocks - specifically, NVDA stock prices dropped by almost 10% in a single session.
But the big news for investors is that bonds have started to exhibit one of their key features again.
For the first time in a few years, bonds are acting again as a hedge against stock market drawdowns.
Or in other words: after a period of positive correlation which wrecked 60/40 portfolios, the stock/bond correlation is turning negative again.
This is a huge deal.
The chart above shows the 6-month (120 trading days) correlation between the S&P500 and 10-year Treasury future prices.
The correlation was negative for most of the last 15 years: this means investors could count on bonds acting as a diversifier during periods of equity drawdowns.
But as you can see from the chart, this wasn’t always the case: for most of the ‘80s and ‘90s bonds and stocks were doing pretty much the same thing at the same time – they were positively correlated.
The same happened in 2022-2023 as inflation was out of control.
Hear me out now, because this is the key message you should bring home.
When the stock/bond correlation changes sign, we are looking at tectonic macro shifts with huge implications for cross-asset portfolios.
This is because ''bad news is good news'' doesn't work anymore.
The market has switched into a regime in which:
Bad news is actually bad news.
Once bonds start acting as a diversifier for risky assets, it's likely we are on the verge of a massive regime change in macro and markets.
Macro tectonic shifts are happening.
The launch of my Macro Hedge Fund is now imminent.
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