‘Higher For Longer’ Getting Priced
August has continued its theme of frustrating investors where for the third week in a row pretty much everything declined with the exception of the U.S. dollar and cash. We have reached a point where all the major averages have broken down through their 50-day moving averages and undergone a meaningful correction since the late-July highs. From their recent highs, the S&P 500 is down nearly 6%, the Nasdaq -7.5%, the Russell 2000 -7%, with the Dow fairing best at -3.0%. The key level to watch for on the S&P 500 is the 100-dma at 4,290 and if that gives way the 200-dma comes in around 4,130. Both levels are realistic targets for this corrective phase, but as I said last week – I think investors with a time horizon that extends beyond their nose should be more aggressively buying stocks on a dip below 4,200 down to 4,000. If we were to take out 4,000 on the downside (long way from here to there) then all bets are off as things would have likely changed in a manner that a reassessment is necessary.
As they say, “mood follows price” which is exactly what’s happened over the past three weeks with the slide in asset prices. Three weeks ago, the percentage of bullish newsletter writers in the investor’s intelligence polls was a lofty 57.1% (matching the November 2021 high), it fell to 52.2% two weeks ago, and then slipped to 47.1% last week. The CNN Fear and Greed Index slipped into fear territory last week at 43 – half the 82 level this index was at a month ago. Other sentiment and technical signals are also flashing short-term oversold levels which is good to remove some of the froth that existed in late-July.
The ’why’ for explaining the reasoning behind the markets slide are plenty: 1.) sentiment, positioning, and investor expectations got a little frothy and ahead of themselves at the end of July, 2.) valuations got stretched to the upside, 3.) corporate earnings were good, but not great (given lofty valuations), and 4.) economic growth remains stronger than expected which has forced the Fed to maintain a hawkish stance. It’s this last point that is having the most material impact in my opinion as it has forced the bond market to reprice interest rates ‘higher for longer’. The futures curve has pushed rate cuts out to the back half of next year and the number of cuts is down to four (from a higher Fed Funds level) from as many as seven at its peak. As a result, we’ve seen the yield on the 30-year T-note increase by 63 basis points since July 19th (3.83% to 4.47%). The yield on the 10-year T-note has risen by 59 basis points – from 3.74% to 4.33% over the same time frame. While short-term rates are little changed with the 2-year Treasury yield rising from 4.84% on July 20th to 4.92% on Friday – this is the yield most closely tied to the Fed Funds rate.
What we have here is a bear-steepening in the curve with the long-end catching up to the short-end and being forced to reprice the ‘higher for longer’ scenario. This could all change following a couple of weak employment reports, a geopolitical disruption, and/or a steeper decline in inflation readings, but for now this is the way it is. As a result, we are in a window where the 2022 nightmare for asset prices is being revisited across capital markets. The U.S. dollar and cash representing the only places to preserve capital while everything else wilts away. Higher long-term rates cause a tightening in financial conditions, a stronger dollar, and a lower P/E multiple for stocks. Sure, you can make it more complicated than that if you need to, but why bother when it can be as simple as that. I’ll get into some more thoughts on the bond market below, but first I have couple comments on the U.S. dollar and economic data.
All the crypto and gold perma-bulls are getting a fresh reminder of why the U.S. dollar’s place as the world’s reserve currency remains firmly ensconced. Without question anyone looking at the long-term trajectory of the U.S. debt situation sees a fiscal ticking time bomb. And sure, at some point it will matter, but recent events only reinforce the reality that the global monetary system is built around the U.S. dollar and that it is going to be hard (if not impossible) to unseat it in the near future. Despite recent events of a credit downgrade by Fitch (the notion that the U.S. would ever default is absurd), traction on the establishment of a BRICS currency backed by gold to compete against the dollar, mounting debt instability and a daily reminder of our broken political system (it’s as if it’s become a competition for how many indictments we can rack up for Hunter Biden and Donald Trump) the dollar has rallied. Yes, the structural nature of the U.S. deficit situation will remove some flexibility from fiscal policymaking in the future, but this is no different than the likes of Europe, Japan, China, Canada… Bottomline, the dollar is the best game in town whether you like it or not. A reality reinforced by a tweet from New Low Observer that referenced an article published in BusinessWeek back in 1978 pontificating on the demise of the world’s reserve currency. Here we are 45 years later, and the arguments are no different today than were being made back then.
The U.S. dollar’s reserve currency status will always be under threat, that’s what happens to whoever and/or whatever is on top, but some champions are more difficult to topple than others. Never is that clearer than with the U.S. dollar. I’ll leave it at that.
As for the economy, admittedly I’m torn and unsure about what the future holds. Following some of the recent economic releases measuring the health of the U.S. economy (retails sales, industrial production, regional Fed surveys) the Atlanta Fed GDPNow estimate for Q3 has shot up to 5.8%. It’s unlikely that it will hold at this level throughout the quarter (the St. Louis Fed is around 0.5% for Q3), but it just reinforces the reality that the U.S. economy has been more resilient than most have expected this year. Could it remain this way? Sure, we very well could have struck the perfect balance of fiscal support via the Chips Act and Inflation Reduction Act that offsets the 525 basis points of monetary tightening, engineers an immaculate disinflation, and sticks the historically elusive soft landing.
The alternative is that we are entering the eye of storm when it comes to truly measuring the ‘long and variable’ lags inherent in monetary tightening cycles. These lags coincide with a fiscal impulse that will begin to fade in 2024 and beyond. David Rosenberg published an outstanding piece in one of his daily commentaries last week on policy lags in which I’m going to take the liberty of reciting some stats in the bullet points below. But first a summary of his thoughts:
“As we said the other day — the typical lag from the time of the first-rate hike to the date of the NBER recession is 22 months. Not 22 days, not 22 weeks — 22 months. For those continuing to ask “where is this recession, already?” They were asking the same thing through all of 2000 and 2007, if you recall. The Fed began tightening 17 months ago, not 22 — so let’s see how things unfold by the fourth quarter of this year and not jump to the conclusion that Biden’s industrial policy has managed to defeat the business cycle. If you recall, FDR’s massive New Deal did not stop the Great Depression (remember that the 1937-38 double-dip downturn was worse in magnitude than the 2008-09 Great Recession) — World War II did.
Leading Economic Indicator (LEI) – the average lag from the peak in the LEI to the start of a recession is 13 months. The current cycle has been 18 months, so a bit longer than the 17 months in the late-80’s, but a little less and the 21 months in 2006.
The New York Fed Recession Probability Model – the clock starts when the model crosses above 70% with the average lag being 10 months. As for the current cycle we are in month 9 and the lags have been as long as 14 months (late-70’s) and 16 months (2007).
2s/10s Inversion – the average lag from the time the 2s/10s yield curve inverts to the start of recession is 10 months. We are currently in month 13, which is on par with the 2001 recession and a little less than the lag in the 2007 cycle.
First Fed rate hike – the average lag from the Fed’s first-rate hike to the recession is nearly 22 months. We are in month 18, so still too early for the all clear declarations.
Look, without question this cycle is unique given we are coming off a once in a generation pandemic which caused a whipsaw two-month recession in early-2020 and then a violent expansion in late-2020/2021. Prior to the pandemic we were clocking the longest economic expansion in U.S. history. Yes, we could be in the early stages of a sustained expansion right now, but we could also be in the early stages of an economic downturn that ends in a recession. It’s difficult to make a conclusion with conviction either way at this moment. What I do know is that the Fed has set out on a historically aggressive monetary policy tightening campaign with the intent to bring down inflation, weaken the labor market, and slowdown the economy. It’s my view that the inflation dragon has been slayed either by the Feds efforts or the natural thawing of supply chain disruptions (the why is less important than the result), but we don’t have enough time or data to conclude that the lags we’ve seen in prior business cycles have no relevance to the current business cycle. I just don’t think that’s a realistic or objective way of analyzing the data or history.
Consider mortgage rates as an example. With each passing day 30-year mortgage rates are marking a new high going back to the turn of the century. Irrespective of the reality that home prices remain firm in large part because of the dearth of inventory (no one with a low-rate mortgage wants to sell their home), common sense alone tells you that a home buyer can afford much less of a home with a financing rate at 7.2% today versus 3.5% two years ago. Below is a chart of the U.S. 30-year real rate (subtracting inflation from the nominal rate – a real return less inflation) which has risen from -0.5% in 2021 to 2.08%. This recent move pales in comparison to the move in 2007 that set off the GFC. Why is today so different than back then? I’m not insinuating today is the same as then, but the global financial system operates off credit, where the cost of credit has moved materially higher in the last 18 months. Given the level of refinancing and terming out of maturities during the pandemic it’s not until we get into 2024 and 2025, when these creditors must refinance, that we’ll learn the true impact of this rise in the cost of capital.
As an aside, if one were to apply economic theory to an asset like equities which is supposed to carry a roughly 5% equity risk premium to the risk-free rate – this rise in real rates gets you to a level on the stock market that is some 60% lower than current levels. Goes to show just how flawed economic theory can be at times, but it doesn’t render its message completely useless.
Let me close with some thoughts on the bond market and this latest spike in yields at the long end of the curve. As I said above, it’s my view that it’s the Fed’s hawkish tone (was clear in the latest set of FOMC minutes) that has forced the market to price in this “higher for longer” narrative. Without question the Fed is holding such a line because the data has led it to such a stance, after all they are data dependent. But just as they were late to the party in not recognizing the budding inflationary risks back in 2021, I think they are making a similar mistake on the opposite end by overtightening while not executing enough patience to assess the impacts of the tightening that is just now working its way through the system. All the increase in nominal 10-year yields over the past month is the result of real rates going higher – inflation expectations have been flat to modestly lower. I apologize for the nerdiness of this thinking, but understanding the mechanics is important because it will have market implications going forward. Even if the Fed holds the line with no more rate hikes but continues to maintain the ‘higher for longer’ narrative and keeps interest rates at the long end of the curve where they are and inflation continues to fall, it will equate to a passive tightening in policy.
Such a sequence will not be kind to equity valuations as multiples will contract and even more so if economic growth weakens. However, the +300 basis points increase in real interest rates over the past two years (real rates have gone from -100 basis points to +200 basis points) makes longer duration Treasuries one of the more compelling investment opportunities in the capital markets. The San Francisco Fed released a paper last week showing that come this time next year the rental components of the CPI index will be trending flat or even negative on a year-on-year basis. If that ends up being the case and holding everything else constant, we’re talking about headline inflation falling to +0.5% by next summer. I understand there are a lot of moving parts to this analysis, but if such a scenario plays out then a buyer of 10-year Treasury bonds today at 4.30% is looking at a real yield of around 380 basis points. Compare this to the earnings yield on the S&P 500 (a nominal yield in that it includes inflation) of a mere 5%. Its dividend yield is 1.7%.
All I’m getting at is that no matter how one measures inflation, if real yields are in the vicinity of +300 - +400 basis points as inflation continues to come down then you’re looking a historically lucrative investment opportunity on an asset that has little to no credit risk. The average (and median) “real” or inflation-adjusted 10-year note yield over the past three decades is 150 basis points. If the San Francisco Fed forecast ends up being accurate where inflation prints slip to 1.0% or lower, then we could be looking at a 10-year Treasury yield around 2.5%.
Look, I could go through an array of scenarios to say what I’m trying to say – I think its prudent for investors to be incrementally adding longer-duration Treasuries to their portfolio. Unfortunately, my initial foray into this space was early and wrong, but I’ve refrained from adding to positions all year, instead focusing on building up portfolio allocations on the short end of the curve. However, discipline, prudence, and opportunity now appear to be lining up for investors to start extending duration in the Treasury market. I see the upside to rates as rather limited in that the yield on the 10-year could rise from today’s level of 4.3% to 4.7% which is why I would advocate an incremental approach, but I do think it’s an investment that will generate a positive return over the next 12 to 24 months.
As for the week ahead, we have Powell speaking at Jackson Hole on Friday and Nvidia’s earning release on Wednesday as the two key events. Other than that, it’s quiet a week on the data front, but will get much busier following the Labor Day holiday.
I will not be penning a missive next week as I will be traveling and have a jam-packed calendar of client meetings. So, have a great holiday and stay safe.
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