Everything Is Trading Off Yields And The Dollar
Equity markets are off to a rough start to kick off the year as the weight of higher yields and a stronger dollar are getting too heavy, especially for an asset class priced for perfection at 22x forward earnings. It was a rough week for the major averages: the Dow and S&P 500 were down -1.9% apiece; the Nasdaq lost -2.3%; and the rates-sensitive Russell 2000 was crunched -3.5%. The S&P 500, Dow, Russell 2000, and global MSCI index have all given up the Trump bump and are piercing levels not seen since before the election. Only the Nasdaq has held on to some of its gains, but that isn’t saying much as it's roughly 2% higher than where it closed on November 5th. The trading in recent weeks and even months has been choppy with a clear downward bias, and the persistence of such a backdrop is likely to frustrate many investors until we see a material change in the setup - policy, valuations, growth, sentiment, positioning, inflation, and interest rates are all acting as headwinds at the moment. The percentage of S&P 500 components above their 50-day SMA is down to 16.10%. This is a level worth watching as it has represented an oversold level that, in the past, marked the last part of a decline before a tradeable bounce commenced.
However, it's important to discern the difference between a short-term countertrend bounce versus a resumption of the bull market that began back in October 2022. On a short-term tactical basis, I think equities are setting up well for a rally, but I find myself cautious and skeptical about the bull market in equities until new all-time highs are reached – take out the December 6th closing high of 6090. Remember the broadening-out narrative being promoted by all the talking heads at the end of last year and coming into 2025? Well, that call isn’t shaping up so well, with U.S. small-cap stocks sliding to their lowest level in three months and back in official correction (-10% from highs) territory.
Rather than focusing just on price, when you look under the hood at the earnings setup for this broadening out thesis, it is difficult for me to jump on the bandwagon that this is where investors should be risking their hard-earned capital. Have a look at the table below comparing the sales and EPS growth rates of the Mag7 relative to the rest of the 493 companies that make up the S&P 500. Consensus estimates for 2024 have sales and EPS growth for the Mag7 increasing 15% and 33%, respectively, compared to +3% for the other-493. Come on, Corey, don’t you see the inflection from 2024 to 2025 and 2026 where the rates of change for these two groups are flipping? The other-493 is expected to see EPS growth go from +3% in ’24 to +11% in ’25, and then +13% in ’26 compared to decelerating EPS growth for the Mag7 (+33%, to +18%, to +16%). Yes, yes, I see it too, but put me in the camp of “I’ll believe it when it happens”. I have a hard time envisioning how the other-493 is going to see sales and earnings growth accelerate dramatically with nominal GDP growth slowing (not contracting but 2025 GDP is expected to moderate from 2024’s breakneck pace), interest rates rising, the U.S. dollar rising, and profit margins coming under pressure from rising COGS. Look, I’ll be happy to eat crow on this one as the U.S. economy and equity markets will be in a better place if I am wrong, but my models just aren’t spitting out the same constructive forward forecast.
Speaking of the U.S. dollar index, it is riding a six-day winning streak and up in 14 of the past fifteen weeks (see chart below) as it eclipses the 110 mark for the first time since November 2022. We are witnessing a meaningful tightening in financial conditions with the long end of the Treasury yield curve at new cycle highs and the dollar at its highest level since November 2022. Anyone recall how difficult 2022 was to navigate where both stocks and bonds traded down 20% - not saying we’ll see that level of pain play out again, but cash and gold were two of only a few asset classes that acted as ports in a storm. It will be really interesting to hear to what C-suite executives have to say about this when they report Q4 earnings. Keep in mind that over 40% of revenues from S&P 500 companies are derived from overseas and it doesn’t look to me like this is accounted for yet in 2025 earnings estimates.
One area that is perking up this year after a miserable 2024 is the energy sector where WTI has moved up to $77 per barrel, its highest level since early October. No doubt, energy is a stodgy, boring, cyclical industry that rightfully doesn’t garner the same level of excitement as Tech, but it is the quintessential geopolitical hedge among the sectors that make up the stock market. What we’re seeing play out is the “drill baby drill” mantra getting drowned out by recent sanctions against Russia and likely upcoming sanctions against Iranian supplies once the Trump administration takes power. Meanwhile, we have OPEC+ remaining disciplined on output cuts (we’ll see where this goes come Summer) and a cascade of cold weather blanketing the U.S. With compelling valuations, bombed out positioning/sentiment, capital investment discipline, and strong balance sheets, this is one area that sets up constructively to kick off 2025.
As for bond yields, they continue their relentless march higher since the Fed kicked off its easing cycle last September. It’s important to have some context for this game of ‘cat and mouse’ being played out by the Fed and markets going back to the cycle high print of 5% on the 10-year T-note in October 2023. Back then, the Fed’s focus was on regaining its credibility after it missed the inflationary spike in 2022, which took the year-over-year change in CPI to +9%. By the Fall of 2023, the Fed had hiked fed funds to 5.375%, inflation was rolling over, and they began guiding markets to expect a shift in policy from a tightening bias to a loosening bias. That’s when the markets started to price in 50 basis points of rate cuts in 2024, and then as we moved into early 2024 with a couple of favorable CPI prints and some additional encouraging words of a Fed pivot, the market got ahead of itself by pricing in -165 bps of cuts for 2024 and by the February the 10-year T-note yield traded down to 3.8%.
Incoming data didn’t corroborate this aggressive move lower in yields, and the Fed had to push back on the markets with its dot-plot forecasting only 3-4 cuts in 2024. So, the bond market had to reprice and the yield on the 10-year T-note shot up to 4.75% by April 2024. Equities weren’t affected too much because economic and earnings growth was strong, while inflation prints were trending in the right direction.
Fast forward to today and we have a similar scenario playing out. At the September 2024 yield low of 3.65%, the market had nine cuts totaling -220 basis points of cuts being priced until the end of 2025. But the Fed’s dot plot were for only 4 cuts and that is when the current problems for the Treasury market began (the market was way offsides). The Fed cut -100 basis points by the end of 2024 and tilted more hawkishly from its prior guidance. It goes to show how words matter more than deeds. That was the moment that the bond rally got snuffed out. Then, at the December 18th FOMC, the Fed went to two cuts for the 2025 dot plot meeting from four, and at that point, the markets were still discounting nearly four cuts, with the 10-year T-note yield sitting at 4.4% heading into that FOMC meeting. But now the market is pricing in just -30 basis points of rate cuts for 2025 even though the Fed is currently at -50 basis points which is how we get to over 4.8% on the T-note yield.
Therein lies the opportunity because just as the bond market overdid it on one side of the equation last September, it has swung the pendulum too far the other way, just as it did in April of last year — the last time we made a run for 4.7% on the 10-year T-note yield. We have reached a point where there is barely more than one cut being priced in now for 2025 and not fully priced in until June. The market has front-run Fed in the other direction, and it has priced at a terminal rate of 4%, even though this hawkish Fed is still 3% on this score. I’m not suggesting that bonds (especially longer-duration bonds) are a screaming buy. Still, current yield levels make them a competitive alternative to richly priced equities with much lower volatility. At 4.80%, the 10-year T-note yield now exceeds the 4.75% average since 1790 (from the current Barron’s).
It’s fascinating to contemplate the psychological shift that has taken shape among the investment community where 4.5% cash yields and 6% investment grade credit instruments are being scoffed at, a complete 180 from 5 years ago when investors would have been grateful to get 3%. Look, I can understand the millennial generation who are lite on assets feeling as if they have no other choice than to take significant risks (YOLO – You Only Live Once) to catch up to where they need to be, but if you’re older and have already procured your nest egg – there is no need to try and keep up with your neighbor or a generation of investors in the accumulation stage of their life cycle.
Two years of super-sized stock market returns have caused investors to throw caution to the wind and embrace the new era philosophy of “number go up” with little to no consideration for risk management. Replete with both a sense of bravado, entitlement, and complacency. Back to the Fed for a second. In the aftermath of Friday’s employment report, we are just a +0.3% MoM reading away on the core CPI (for any month in the next few) to cause the futures market to begin to price in rate hikes. I don’t expect to see that, but who knows what auto insurance and health care premiums will do as they get reset early in the New Year. We can’t rule out the market having gone from discounting massive rate cuts to virtually nothing and then extending the process to pricing in hikes. It is not impossible, especially with a central bank completely data dependent and the data in question are either lagging or contemporaneous in nature.
Usually, when the Fed cuts rates -100 basis points in a three-month span, interest rates in the consumer and business sectors go down -70 basis points on average; this time, they have risen +70 basis points, which has never happened before. We are living through history as illustrated in the chart below from Augur Infinity plotting the return of 10-year T-note in prior cutting cycles:
Observing yields act this way and the uncertainty of the incoming administration's policy priorities causes this humble analyst to consider how much of this upward pressure on rates is driven by the U.S. fiscal standing. The setup for Trump this go-round is not nearly as forgiving as 2017. Back then, the fiscal deficit as a share of GDP was half what it is today, the debt ratio more than 20 percentage points lower, and interest costs accounted for 8% of the revenue stream versus 16% today (increasingly posing a structural fiscal problem now and in the future). It makes you wonder if Fed policy is being steamrolled by fiscal dominance. Said differently, is the size, makeup, and growth of the debt and deficits of the world’s reserve currency dictating the move in interest rates? Relegating monetary policy to sideshow status.
Luke Gromen publishes a weekly publication that has been grabbing my attention over the last several months. He interprets the setup in a much different way than you read or hear about in mainstream publications or even from Wall St. research shops. Here’s a snippet from this weekend’s piece in regards to the complexities being created by the fiscal standing of the U.S. and the Fed’s reaction function:
In 2022, the Fed made a mistake by trying to fight inflation by playing “Volcker 1980” with the US government having a balance sheet of “Argentina 2004” (literally – Argentina debt/GDP was ~120% in 2004), instead of allowing inflation to run “Higher 4 Longer (H4L)” to reduce debt/GDP to more sustainable levels before tightening.
We have been warning since mid-2022 in these pages that this mistake by the Fed would eventually result in the Fed being in a position where 10y UST yields would rise sharply regardless of whether the Fed tightened policy (as the USD got “too strong”, triggering aggressive foreign selling of USTs to raise USDs to service foreigners’ $13T in USD-denominated debt) or loosened policy into still-elevated inflation (as inflation expectations rose.)
In our view, the move in 10y USTs seen above (and by extension, in 10y UK gilts, 10y JGB’s, and other western sovereign bonds) is the beginning of the marking to market of the cornering of the Fed that we have always known would result from the Fed trying to play “Volcker 1980” to fight inflation with a radically different set of circumstances (4x higher debt/GDP than 1980, 2-3x higher deficit/GDP, massively negative Net Int’l Investment Position instead of positive NIIP, significant negative foreign USD-denominated borrowings, massively cash flow negative Entitlement outlays, lack of foreign Central Bank net UST buying, and a much more financialized economy and therefore interest rate sensitive tax receipts.)
As bad as the above is, it is likely going to get worse before it gets better, because Treasury Secretary Yellen shifted the reckoning for the Fed’s mistake from late 2022 (when we initially forecast it would occur) by heavily shifting UST issuance to T-Bills
Much of this T-Bill issuance needs to be refinanced in 1H25…and if it is refinanced at longer durations, that will only put further upward pressure on 10y UST yields… …into US “True Interest Expense” that is already 103% of US tax receipts over the past 4 months… …and into a US government and US (and global) economy that has repeatedly shown that 10y UST yields much above 4.8-5.0% will cause UST market dysfunction and trigger a US (and global) debt spiral.
The above is a setup for a resumption of the 3q22 and 3q23 market regimes of “USD & gold up, everything else down”… and we also know that the 3q22 and 3q23 “US and global debt spiral” regimes have quickly been met with significant injections of USD liquidity, because the Fed’s shadow third mandate still remains in place (aided by the Treasury): UST market functioning.
The chart above from Renaissance Macro suggests the rise in 10y UST yields that has already occurred has put the US into an r > g situation (10y UST yields > US GDP growth). THIS IS CRITICAL:
In an economy like the US which has 125% debt/GDP, 7% deficit/GDP, -79%/GDP Net International Investment Position, and foreigners having $13T in USD-denominated debt, “r” going > “g” is mathematically certain to quickly trigger a debt death spiral for the US and the world, unless either or both US rates (“r”) are cut quickly or US nominal growth (“g”) is accelerated higher…ASAP.
Cet par, “r > g” will accelerate the “USD up, gold up, everything else down” regime we have started…until either more USD liquidity is injected or rates hit levels that make it mathematically obvious the US government cannot afford its interest expense without printing the money…then BTC should join gold in rising, as everything else collapses (stocks, bonds, economies, commodities, etc.)…again, unless requisite amounts of USD liquidity are added. “r > g” means investors with monthly or quarterly mandates should be hedged with puts per our earlier commentary.
This is critical in the context of US debt/GDP at 125% and rising, because it means that any time nominal GDP growth (“g”) is NOT greater than “r”, as noted before, the US (and world) will be quickly heading into a debt spiral (technically, 125% debt/GDP x 4.7% 10y interest rate = 5.9%...which is > nominal GDP growth below):
Fundamentally, US Federal debt has been growing 8% CAGR since 2008 (blue line). Complicating 8% CAGR Federal debt growth since 2008 has been price insensitive buyers of USTs (Central Banks) stopping growing their holdings of USTs on net in 2014 (red):
8% CAGR of US Federal debt v. 0% CAGR of buying of that US Federal debt by price-insensitive buyers was always going to lead to a moment where looser Fed policy or tighter Fed policy drove rising LT UST yields…and per our earlier point, it appears we have now reached that point.
Gold has been the least volatile, cleanest way to play the US debt spiral problem described above, but as we have noted, we also believe that… …stocks (SPX below) and BTC will likely continue to serve as “release valves” for capital escaping USTs and other western sovereign bond markets over time…but as the blue dotted circles in the charts below show, unlike gold, there have been brief but powerful tactical reversals in stocks and BTC v. LT UST futures post-2014 that one should be aware of…and failing a significant injection in USD liquidity ASAP, we appear to be entering another one of those brief tactical reversal periods that require hedging with puts for a brief time.
I know it’s a lot to chew on, and Luke is nothing if not extremely confident in his structural view of the world. I find myself more in agreement than disagreement with him on the structural outlook as well the likely path it leads to – financial repression and/or politicians attempting to inflate our way out of this global over-indebtedness dilemma, but where the real value in this view comes to light is in the timing. And on that front, it’s anyone’s guess. Nevertheless, it’s worth contemplating and monitoring through time as without question matters, but how it evolves is very nuanced.
Let me close up with some brief thoughts on the markets. I think yields and the dollar are marking extremes that matter to equities. If they continue to move higher then I think stocks continue to move lower (faster). However, if they stop their climbs and even reverse then I think stocks catch a bid and rally can ensue. How it evolves from there is something we’ll continue to adapt and adjust to as it plays out. But the margin of safety in the equity market is razor thin, as it is the case in terms of the credit markets with spreads at cycle lows. Tactically I would consider myself constructive on risk-assets and don’t see anything immediate that causes me a lot of concern. I welcome the froth coming out of an equity market that got way over done relative to fundamentals following the election results.
I remain a long-term holder of gold, consider cash and short-term fixed income instruments as investments that not only preserve capital, but also pay you an ample return while providing optionality to act upon opportunities if/when they present themselves. Lastly, I think the more patient you are this year with letting opportunities come to you rather than getting FOMO’d into chasing them higher, the better position you’ll find your capital at the end of the year. Volatility will be both a friend and enemy to investors this year, depending on how you use it to your advantage or detriment.
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