Exiting my US long term bond short position! How will the tightening cycle play out?
Situation
At the start of this year, I anticipated the inflation in the US to be persistent rather than “transitory”. With that view, I have purchased shares in the ProShares UltraShort 20+ Year Treasury ETF. I was right on my assessment and now with TBT returning more than 60% I only regret not buying enough. A lot has happened in the last few months. The Federal Reserve raised its target range for the federal funds rate by 3.75 percentage points since March. Russia invaded Ukraine. China remains locked down. It is time to reexamine my views regarding interest rates and inflation going forward, so I can reassess my positions in TBT.
Interest Rates
Fed Reserve Update
The decisions of the Federal Reserve are the biggest driver of interest rates, which is one of the biggest drivers of inflation, so I’ll begin by examining the next steps of the US Federal Reserve.
Jerome Powell said in a speech at the Brookings Institute (insert date):
It makes sense to moderate the pace of our rate increases as we approach the level of restraint that will be sufficient to bring inflation down. The time for moderating the pace of rate increases may come as soon as the December meeting. Given our progress in tightening policy, the timing of that moderation is far less significant than the questions of how much further we will need to raise rates to control inflation, and the length of time it will be necessary to hold policy at a restrictive level.
One risk management technique for policy is to go slower, he said. Another is to hold the policy rate longer at a higher level.
This is a clear signal that the fed will slow the rate hike in December to just a 50 bps hike rather than the gigantic leap of 75bps in the last few raises.
This is not a surprise as the October inflation data is lower than expected and the street had already been expecting a moderation.
Nevertheless, the markets have reacted very positively with the S&P up 3%, ASX 200 up 1%, Euronext 100 climbing 1.07% today.
Is this over-optimism by the markets? Although the December hike will be smaller than the expected 75bps, a 50 bps hike is not a small increase.
Labour market inflation could be more sticky than previously thought. The November jobs data that came out on the 2nd of December shows that the US jobs market remains strong, show no sign of a slower job market. The Fed has pledged that it “will stay the course until the job is done”. In the scenario of inflation not falling to 2%, the Fed could have another tightening cycle.
Inflation
Below I list down some inflation catalyst in the coming months, things to keep track of
Demand side
Slowing in the US economy
To lead to lower revenues and less hiring
US job market
Needs to be weaker
US wage growth is “well above levels consistent with 2 percent inflation over time” (Powell)
Labour supply needs to grow
Immigration lower than 2019 levels
Labour participating below 2019 levels
November job market still very strong
Supply-side
Supply chains
Supply chain issues are now easing. (Powell)
Both fuel and nonfuel import prices have fallen in recent months
indicators of prices paid by manufacturers have moved down.
Further economic weakness in China whether that is from
Unresolved housing market debt crisis
Surging of Covid cases (happening now)
Political and geopolitical risks
With the next US presidential election in 2024, presidential candidates will be build up rhetoric of being hard on China to attract votes as this approach is proven to garner bipartisan support
A further slowdown and unrest in China would weaken supply chains and increase the cost of products manufactured there. Recently Apple’s production facilities have been affected by the protest of Foxconn workers protesting the prolonged covid restrictions in the country.
Deglobalisation is inflationary
Related to potential supply chain issues. The supply chain disruptions over the last 5 years whether it’s in the form of tariffs, covid, or covid lockdowns, it has gotten companies to reshore their supply chains. Just look at apple, that is trying the shift supply chains away from China. Forced spending on building new supply chains helps offset a downturn, but extremely bad for profits.
What the market is thinking
Expects Fed to tighten by 50bps in December
Final hike in Jan to the peak rate of 4.5 -4.75
Fed likely to keep the rates high for most of next year
US economy to narrowly miss recession in 2023 (could fall into slight recession?)
Only in the back half of 2024 will the pace of growth pick back up. Fed reduces rate back to neutral at 2.5%. (don’t think the Fed is going to start lowering rates starting back half of 2024, interest rates could stay high for a little longer)
2023 gdp growth to 0.3%, 1.4% in 2024
Inflation seems to have reached a turning point
Slowing in housing prices and rents
Core goods inflation should turn to disinflation as supply chains normalise
Demand shifts to services away from good
Used car prices may be down 10-20% next year
Core pce to slow from 5% to 2.9% in 2023, 2.4% in 2024
Higher interest rate translate to higher borrowing costs which continues to weigh on consumption, continue in 2024, cumulative effects of past policy hikes to flow through to households
Rebound in real disposable income growth in 23 because inflation pressures abate and job growth is positive
Slower consumption and rising income should raise savings rate from 3.2% to 5.1% in 2023, 6.2% in 2024
In the mist of a sharp housing correction, expect a double digit decline in residential investment to continue, dont expect a commensurate drop in home valuations, predict a 4% drop in house prices in 2023.
Further pricing declines are likely in the years ahead but that is a milder dropoff in valuations compared to the magnitude of dropoff in housing activity
Residential wealth and real estate wealth will be a strong backdrop for household balance sheets
Going forward, mortgages rates are going to fall again after reaching this peak of 7%, with healthy job gains and increase in real disposable income growth, affordability should begin to ease somewhat, starting in the back half of 2024
Turning to the labour market, while signs of falling inflation is important to the fed, so are signs of the labour market is softening, expect softer demand for labour and labour supply gains to create the slack in the labour market the fed is looking for
Job growth to fall below the replacement rate by Q2 of 2023, pushing up the unemployment to 4.3% by the end of next year and 4.4% by the end of 2024.
In sum, US economy is at a turning point, not a turning point towards recession but a turning point toward what is likely to be 2 sluggish years of growth in the economy
The Fed’s tightening cycle is working as it should, labour market is softening, the inflation rate is coming down, that puts the US economy on track for soft landing.
US recent job report not looking good at all, still incredibly strong
What to do with my TBT position?
I think the only scenario that would drive the shares to go down is the one where the market expects the Fed to start easing monetary policy surprisingly early. For that to happen we should see:
A really soft landing which implies
Inflation fall back to 2% relatively quickly, which means
Supply chains issues dealt with
Lots of people coming back to work
Migrants coming in US to work
A growing demand for US government bonds
Could happen in a bear market.
But this raises the question of is shorting long term US govt bonds the best way to hedge a potential next wave of tightening.
Why did TBT not react to the surprise of stronger labour markets data?
How might the monetary tightening play out? (Bridgewater publications)
In this publication, Bob Prince and Greg Jensen share their thoughts on the potential way the monetary tightening may play out. I summarise their thinking below:
Both: The Fed needs to engineer a significant weakness in demand to bring the inflation down. This is going to be very bearish for equity markets (Bob: less bearish; Greg: more bearish).
Bob
Fed could take its foot off the gas relatively early and need to restart the tightening cycle.
Inflation is essentially too much money chasing a given amount of output.
Fed has already tightened and continues to tighten, a slowdown/downturn can be expected.
Inflation has started to trend down. Central banks will step on the brakes a little bit, because it sees the inflation rate trending down. Markets at that point would be discounted, so the pause will cause a rally in the asset markets, which will then support the economy. This works against the inflation trending lower closer to 2%.
The Fed then faces a higher than 2% inflation rate (3 or 4% for instance) and with the economy doing fine and asset prices recovering, it would have to either:
Initiate another round of tightening to bring the inflation rate down from 4ish% to 2%, or
Accept a higher than 2% inflation rate
Reason for a sticky inflation
Lag-time between central bank action and flow through of economic conditions
Monetary policy lags: 9-12 months (we’re 8 months in right now)
Economic weakness q4 this year q1 2023 which is a spending and income contraction
It would then take another 18 months for spending contraction to lead to wage contraction.
Thus it would take a very long time to bring wage inflation down, and it is likely that the Fed would not have the patience to tighten for that long of a period.
Would the strength of the labour market and consumer spending make the economy more reliant on a tightening?
The economy could be more resilient to a tightening than it did in past business cycles due to better balance sheets, sustained credit flows, and interest rates are low relative to nominal growth. The reversal of the past decade of financial markets outperforming the real economy to the real economy outperforming financial markets means that wage inflation is more entrenched.
Greg
Fed has a serious risk of overtightening. And creating a severe recession.
Doesn't see the balance sheet as healthy as how other people are. Sees a lot of risks globally
alludes to the canadian and UK housing markets.
Global debt levels are high, never have we had such high levels of debt except in 2008. And most of the debt are set at an interest rate lower than today. Once the economy slows it is going to be very hard to stimulate.
The only way to stimulate is through fiscal policy. With a lame-duck government, the US is not likely to pass big fiscal spending until 2024, or until the economic pain gets too much.
The Fed, because of inflation is lagging, and even as markets go down the Fed will not ease because it wants the pain to bring down inflation. (Yet the question of whether they are going to overtighten or not is hard to tell right now due to lag times.)
Lastly, the world has become fundamentally more inflationary than before simply due to reglobalisation. Changing supply chains is expensive. This forced spending offsets the downturn but is extremely bad for profits.
Why consumer spending is on the precipice of weakening? (why the Fed could overtighten)
Biggest divergence between what drives savings rate and what is happening to savings rate.
People are still spending through their healthy balance sheets, all the cash from the easing in the last two years.
The savings rate only rises as the economy starts to slow down and they start getting worried. Taking into account the movement in assets and move in interest rates, the savings rate would typically be way higher than they are.
Factor in demographic and people are losing their savings for retirement.
Extremely lagged movement in the savings rate. As soon as people get laid off, the savings rate rises, which leads to more people getting laid off. We are already seeing massive layoffs in tech. So this process is already starting.
Bob synthesising both views
First order events
Greg: There has been and there will be enough tightening to cause a significant downturn, and it is self-reinfocing. Likely to be a contraction in labour markets and contraction in earnings.
Bob: The Feb has to continue to tighten until they get a contraction in earnings which necessitates a contraction in labour markets. But wage inflation does not drop nearly enough.
Second order events
Greg: That downturn is likely to be self-reinforcing which would be very difficult to get out of and it is going to take a really serious decline to get everybody to agree to do that.
Bob: The Fed is quick to take its foot off the brakes and that there’s no self-reinforcing process. Fed see the good news in the decline in inflation the Fed chicken out sooner from the tightening and the economy never hits the self-reinfocing downturn.
Third-order
Whatever happens third-order happens from there.
The market is not discounting a substantial decline in earnings.
My comments:
I find myself agreeing with Bridgewater here. I think inflation would be harder to tame, especially now we’ve seen the job market not slowing down.
US adds 263,000 jobs in November as unemployment rate stays at 3.7%
Jobs market remains strong even as Fed imposes biggest series of rate rises in decades in effort to tame inflation
ADP’s chief economist, Nela Richardson, said it was still too early to say but it seemed the rate rises were filtering through to hiring decisions.
In November, average hourly earnings for all employees on private nonfarm payrolls rose
by 18 cents, or 0.6 percent, to $32.82.
Decision: sell TBT
US investors bracing for recession now. I think the recession could very well be more potent than people expect.
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